American Economic Review: Papers & Proceedings 2008, 98:2, –37
http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.2.
RICHARD T. ELY LECTURE
The Economics of Climate Change
By Nicholas Stern*
Greenhouse gas (GHG) emissions are exter-
nalities and represent the biggest market failure
the world has seen. We all produce emissions,
people around the world are already suffering
from past emissions, and current emissions will
have potentially catastrophic impacts in the
future. Thus, these emissions are not ordinary,
localized externalities. Risk on a global scale
is at the core of the issue. These basic features
of the problem must shape the economic analy-
sis we bring to bear; failure to do this will, and
has, produced approaches to policy that are pro-
foundly misleading and indeed dangerous.
The purpose of this lecture is to set out what
I think is an appropriate way to examine the
economics of climate change, given the unique
scientific and economic challenges posed, and
to suggest implications for emissions targets,
policy instruments, and global action. The sub-
ject is complex and very wide-ranging. It is a
subject of vital importance but one in which the
economics is fairly young. A central challenge
is to provide the economic tools necessary as
* London School of Economics and Political Science,
Houghton Street, London WC2A 2AE, UK (e-mail:
n.stern@lse.ac.uk). I am very grateful for the advice and
comments of Claire Abeillé, Dennis Anderson, Alex
Bowen, Sebastian Catovsky, Peter Diamond, Simon Dietz,
Ottmar Edenhofer, Sam Fankhauser, Graham Floater, Su-
Lin Garbett, Ross Garnaut, Roger Guesnerie, Geoffrey
Heal, Daniel Hawellek, Claude Henry, Cameron Hepburn,
Paul Joskow, Jean-Pierre Landau, James Mirrlees, Ernesto
Moniz, Steven Pacala, Nicola Patmore, Vicky Pope, Laura
Ralston, Mattia Romani, John Schellnhuber, Matthew
Skellern, Robert Socolow, Martin Weitzman, Dimitri
Zenghelis, and all of those who worked on and guided the
Stern Review team. The views expressed here are mine and
do not necessarily reflect the judgements or positions of
those who kindly provided advice, or of the London School
of Economics, or of the UK Government, for whom I was
working while leading the Stern Review on the Economics
of Climate Change. This is dedicated to my close friend,
distinctive and distinguished economist and fine man,
Andrew Glyn, who died on December 22, 2007, and whose
funeral took place in Oxford, UK, on the same day as the
Ely Lecture, January 4, 2008.

quickly as possible, because policy decisions are
both urgent and moving quickly—particularly
following the recent United Nations Framework
Convention on Climate Change (UNFCCC)
meetings in Bali in December 2007. The rel-
evant decisions can be greatly improved if we
bring the best economic analyses and judge-
ments to the table in real time.
A brief description of the scientific processes
linking climate change to GHG emissions will
help us to understand how they should shape the
economic analysis. First, people, through their
consumption and production decisions, emit
GHGs. Carbon dioxide is especially important,
accounting for around three-quarters of the
human-generated global warming effect; other
relevant GHGs include methane, nitrous oxide,
and hydrofluorocarbons (HFCs). Second, these
flows accumulate into stocks of GHGs in the
atmosphere. It is overall stocks of GHGs that
matter, and not their place of origin. The rate
at which stock accumulation occurs depends on
the “carbon cycle,” including the earth’s absorp-
tive capabilities and other feedback effects.
Third, the stock of GHGs in the atmosphere
traps heat and results in global warming: how
much depends on “climate sensitivity.” Fourth,
the process of global warming results in climate
change. Fifth, climate change affects people,
species, and plants in a variety of complex ways,
most notably via water in some shape or form:
storms, floods, droughts, sea-level rise. These
changes will potentially transform the physical
and human geography of the planet, affecting
where and how we live our lives. Each of these
five links involves considerable uncertainty. The
absorption-stock accumulation, climate-sen-
sitivity, and warming-climate change links all
involve time lags.
The key issues in terms of impacts are not
­simply or mainly about global warming as
such—they concern climate change more
broadly. Understanding these changes requires
 AEA PAPERS AND PROCEEDINGS
specific analysis of how climate will be affected
regionally. Levels and variabilities of rain-
fall depend on the functioning of weather and
­climate for the world as a whole. As discussed
below, temperature increases of 4–5°C on aver-
age for the world would involve radical and
dangerous changes for the whole planet, with
widely differing, often extreme, local impacts.
Further, the challenge, in large measure, is one
of dealing with the consequences of change
and not only of comparing long-run equilibria.
Under business as usual (BAU), over the next
two centuries we are likely to see change at a
rate that is fast-forward in historical time and
on a scale that the world has not seen for tens of
millions of years.
This very brief and oversimplified descrip-
tion of the science carries key lessons for eco-
nomics. The scientific evidence on the potential
risks is now overwhelming, as demonstrated in
the recent Intergoverrnmental Panel on Climate
Change (IPCC) Fourth Assessment Report, or
AR4 (IPCC 2007). Like most of those here today,
I am not a climate scientist. As economists, our
task is to take the science, particularly its analy-
sis of risks, and think about its implications for
policy. Only by taking the extraordinary posi-
tion that the scientific evidence shows that the
risks are definitely negligible should econo-
mists advocate doing nothing now. The science
clearly shows that the probability and frequency
of floods, storms, droughts, and so on, is likely
to continue to grow with cumulative emissions,
and that the magnitude of some of these impacts
could be catastrophic.
While an understanding of the greenhouse
effect dates from the nineteenth century, in
the last decade, and particularly in the last few
years, the science has fortunately started to give
us greater guidance on some of the possible
probability distributions linking emissions and
stocks to possible warming and climate change,
thus allowing us to bring to the table analytical
tools on economic policy toward risk.
The brief description of the science above tells
us that GHG emissions are an externality which

Joseph Fourier recognized in the 1820s (Fourier 1827)
that the atmosphere was trapping heat; three decades later,
John Tyndall (1861) identified the types of gases responsi-
ble for the trapping; and at the end of the century, Svante
Arrhenius (1896) gave calculations of the possible effects
of doubling GHGs.
MAY 2008
is different from our usual examples in four key
ways: (a) it is global in its origins and impacts;
(b) some of the effects are very long term and
governed by a flow-stock process; (c) there is
a great deal of uncertainty in most steps of the
­scientific chain; and (d) the effects are potentially
very large and many may be irreversible. Thus,
it follows that the economic analysis must place
at its core: (i) the economics of risk and uncer-
tainty; (ii) the links between economics and eth-
ics (there are major potential policy trade-offs
both within and between generations), as well as
notions of responsibilities and rights in relation
to others and the environment; and (iii) the role
of international economic policy. Further, the
potential magnitude of impacts means that, for
much of the analysis, we have to compare strate-
gies that can have radically different develop-
ment paths for the world. We cannot, therefore,
rely only on the methods of marginal analysis.
Here, I attempt to sketch briefly an analysis that
brings these three parts of economics to center
stage. It is rather surprising, indeed worrying,
that much previous analysis of practical policy
has relegated some or all of these three key
pieces of economics to the sidelines.
The Structure of the Argument.—The struc-
ture of the argument on stabilization is crucial,
and we begin by setting that out before going
into analytical detail. The choice of a stabili-
zation target shapes much of the rest of policy
analysis and discussion, because it carries strong
implications for the permissible flow of emis-
sions, and thus for emissions reductions targets.
The reduction targets, in turn, shape the pricing
and technology policies.
Understanding the risks from different strate-
gies is basic to an understanding of policy. Many
articulated policies for risk reduction work in
terms of targets, usually expressed in terms of
emission flows, stabilization levels, or average
temperature increases. The last of these has
the advantage that it is (apparently) easier for
the general public to understand. The problem
is that this apparent ease conceals crucial ele-
ments that matter greatly to social and economic
outcomes—it is the effects on storms, floods,
droughts, and sea-level rise that are of particular
importance, and a heavy focus on temperature
can obscure this. Further, and crucially, tem-
perature outcomes are highly stochastic and
cannot be targeted directly. Emissions can be
VOL. 98 NO. 2 richard t. ely lecture
more easily controlled by policy. However, it is
the stocks that shape the warming. Thus, there
are arguments for and against each of the three
dimensions. We shall opt for stock targets, on
the basis that they are closest to the phenomenon
that drives climate change and the most easily
expressed in one number.
An alternative focus for policy is the price
of GHGs rather than quantities. In a perfectly
understood nonstochastic world, standard dual-
ity theory says that price and quantity tools are
essentially mirror images and can be used inter-
changeably. However, where risk and uncer-
tainty are important and knowledge is highly
imperfect, we have to consider the relative merits
of each. For the most part, we ignore the differ-
ence between risk and uncertainty here (where
the latter is used strictly in the Knightian sense
of unknown probabilities), but it is a very impor-
tant issue (Claude Henry 2006; Stern 2007, 38–
39) and a key topic for further research.
We begin by setting out some of the major
risks from climate change, and argue that these
risks point to the need for both stock and flow
targets, guided by an assessment of the costs
involved in achieving them. Long-term stabiliza-
tion (or stock) targets are associated with a range
of potential flow paths, although the stock target
exerts a very powerful influence on their shape.
The choice of a particular flow path would be
influenced by the expected pattern of costs over
time. The target flow paths can then be associ-
ated with a path for marginal costs of abatement,
if we think of efficient policy designed to keep
flows to the levels on the path, in particular by
using a price for carbon set at the marginal abate-
ment cost (MAC). Essentially, the economics of
risk points to the need for stock and flow quantity
targets and the economics of costs and efficiency
to a price mechanism to achieve the targets.
A policy that tries to start with a price for
marginal GHG damages has two major prob-
lems: (a) the price estimate is highly sensitive to
ethical and structural assumptions on the future;
and (b) there is a risk of major losses from higher
stocks than anticipated, since the damages rise
steeply with stocks and many are irreversible.
Formal modelling of damages can supple-
ment the argument in three ways. First, it can
provide indicative estimates of overall damages
to guide strategic risk analysis. Second, it can
provide estimates of marginal damage costs of
GHGs, for comparison with MACs. Third, and

most important in my view, it can help to clarify
key trade-offs and the overall logic and key ele-
ments of an argument.
A useful analogy is the role of Computable
General Equilibrium Models (CGMs) in discus-
sions of trade policy. These have much more
robust foundations than aggregative models on
the economics of climate change, yet their quan-
titative results are very sensitive to assumptions,
and they leave out so much that is important to
policy. Thus, most economists would not ele-
vate them to the main plank of an argument on
trade policy. That policy would usually be bet-
ter founded on an understanding of economic
theory and of economic history, together with
country studies and particular studies of the
context and issues in question.
However, as the Stern Review stressed, such
analysis has very serious weaknesses and must
not be taken too literally. It is generally forced
to aggregate into a single good, and in so doing
misses a great deal of the crucial detail of
impacts—on different dimensions and in differ-
ent locations—which should guide risk analy-
sis. It is forced to make assumptions about rates
and structures of growth over many centuries.
Further, it will be sensitive to the specification
of ethical frameworks and parameters. Thus its
estimates of marginal social costs of damages
provide a very weak foundation for policy. This
type of modelling does have an important sup-
plementary place in an analysis, but all too often
it has been applied naively and transformed into
the central plank of an argument.
Our analysis of risks and targets points to the
need for aggregate GHG stabilization targets of
below 550 parts per million (ppm) carbon diox-
ide equivalent 1CO2e2 , arguably substantially
below. This corresponds to cuts in global emis-
sions flows of at least 30 percent, and probably
around 50 percent, by 2050. These cuts may
seem large in the context of (we hope) a growing
world economy, but are not ambitious in relation
to the risks we run by exceeding 550ppm CO2e.
And, given the avoided risks, the costs of around
1 percent of world GDP per annum (see Section
IB below) of achieving this stabilization should
be regarded as relatively low. The carbon price
required to achieve these reductions (up to, say,
2030) would be around, or in excess of, $30 per
ton of CO2.
This paper incorporates many important ele-
ments of the Stern Review, published on the Web
 AEA PAPERS AND PROCEEDINGS
in October/November 2006 (see http://www.
sternreview.org.uk, including Postscript) and
in book form (Stern 2007) a year ago, but goes
beyond it in many important ways—in relation
to subsequent policy discussions, new evidence
and analysis, and discussions in the economics
literature.
There are four further parts to this paper. The
second part focuses on risks and how to reduce
them, and on costs of abatement. The third part
examines formal modelling and damage assess-
ment. The fourth part examines policy, and in
particular the role of different policy instru-
ments. The final part outlines what I see as the
central elements of a global deal or framework
for collaborative policy and discusses how that
deal can be built and sustained.
I.  Stabilization of Stocks of Greenhouse Gases I:
Risks and Costs
A. Risks and Targets
The relation between the stock of GHGs in
the atmosphere and the resulting temperature
increase is at the heart of any risk analysis. The
preceding link in the chain, the way the carbon
cycle governs the process relating emissions
to changes in stocks, and the subsequent link,
from global average temperature to regional and
local climate change, are full of risk as well. But
the stock-temperature relationship is the clear-
est way to begin, as it anchors everything else.
Broadly conceived, it is about “climate sensitiv-
ity”—in terms of modelling, this is indicated
by the expected eventual temperature increase
from a doubling of GHG stocks.
There are now a number of general circula-
tion models (GCMs—also known as global cli-
mate models) that have been built to describe
the links from emissions to climate change.
The large ones work with a very large number
of geographic cells, consume computer time
extremely heavily, and can be run only on some
of the world’s biggest computers. Nevertheless,
particularly if combined with appropriate link-
ing to a large number of other machines, they

Climate modellers tend to define “doubling” in rela-
tion to preindustrial times. The relationship from stock to
temperature increase is approximately logarithmic, so that
doubling from other stock levels would be likely to yield a
similar increase.
MAY 2008
can be run many times for different possible
parameter choices. Such exercises yield Monte
Carlo estimates of probability distributions of
outcomes. A discussion of various methods and
models may be found in Malte Meinshausen
(2006) and in Chapter 1 of the Stern Review.
Figure 1 and Table 1 are drawn from the mod-
els of the UK’s Hadley Centre. The work of the
Hadley Center was a particular focus of models
for the Stern Review for a number of reasons.
First, it is one of the world’s finest climate sci-
ence groups, with a very large computing capac-
ity. Second, it was close by and the staff were
extremely accessible and helpful. Third, its
probability distributions are fairly cautious, bal-
anced, and “middle of the road” (Meinshausen
2006); this judgement is sustained by a com-
parison of their results with the subsequently
published AR4 (IPCC 2007).
Figure 1 and Table 1 present estimated proba-
bilities for eventual temperature increases (which
take time to be established) relative to preindus-
trial times (around 1850), were the world to sta-
bilize at the given concentration of GHGs in the
atmosphere measured in ppm CO2e. Figure 1
portrays 90 percent confidence intervals—
the solid horizontal bars—for temperature
increases. The lower bound (fifth percentile)
is derived from the IPCC Third Assessment
Report, or TAR (Tom Wigley and Sarah Raper
2001; IPCC 2001a, b) and the upper bound is
from the Hadley Center (Hadley Center 2005;
James M. Murphy et al. 2004). The dotted bars
cover the range of the 11 studies examined by
Meinshausen (2006). The bar for 550ppm CO2e
(with a 90 percent interval of 1.5°C to 5.3°C)
approximately represents the possible range for
“climate sensitivity.”
Concentrations are currently around 430ppm
CO2e (Stern Review, Figure 1.1 (Stern 2007,
5)—Kyoto GHGs), and are rising at around
2.5ppm CO2e per annum. This rate appears to be
accelerating, particularly as a result of the very
rapid growth of emissions in China. On fairly
conservative estimates (International Energy

The TAR was without probabilities but Wigley and
Raper produced distributions based on it. The Stern Review
blended the TAR and Hadley because the former was
based on international discussion, but the latter was more
recent. The Stern Review used lower climate sensitivities
than Hadley, although the IPCC’s more recent AR4 (IPCC
2007) is closer to those used by Hadley.
VOL. 98 NO. 2 richard t. ely lecture 

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Figure 1. Stabilization and Eventual Change in Temperature

Source: Stern Review, Table 1.1 (Stern 2007, 16); Meinshausen 2006; Wigley and Raper
2001; Murphy et al. 2004.

Table 1—Likelihood (in percentage) of Exceeding a Temperature Increase

at Equilibrium

Stabilization level
  (in ppm CO2e) 2°C 3°C 4°C 5°C 6°C 7°C
450   78 18  3  1  0 0
500   96 44 11  3  1 0
550   99 69 24  7  2 1
650 100 94 58 24  9 4
750 100 99 82 47 22 9

Source: Stern Review Box 8.1 (Stern 2007, 220) with some added information.

Agency (IEA) 2007), China’s energy-related
emissions are likely to double by 2030, taking
overall emissions from 6–7 to 12–15 gigatons
(Gt). There seems little doubt that, under BAU,
the annual increments to stocks would average
somewhere well above 3ppm CO2e, perhaps 4
or more, over the next century. That is likely to
take us to around, or well beyond, 750ppm CO2e
by the end of the century. If we manage to sta-
bilize there, that would give us around a 50–50
chance of a stabilization temperature increase
above 5°C. This is a high probability of a disas-
trous transformation of the planet (see below).
The issue is still more worrying than that of
dealing with very large damages with very low
probability.
Further, we should emphasize that key posi-
tive feedback from the carbon cycle—such as
release of methane from the permafrost, the
collapse of the Amazon, and thus the destruc-
tion of a key carbon sink, and reduction in
the absorptive capacity of the oceans—has
been omitted from the projected concentration
increases quoted here. It is possible that stocks
could become even harder to stabilize than this
description suggests.


To avoid excessive length of discussion, we focus on
5°C, because it is an extremely dangerous increase and
because its probability of occurrence under BAU is far from full range of possible concentrations and associated prob-
small. In a full analysis, one could and should look at the ability distributions for temperature increases.
 AEA PAPERS AND PROCEEDINGS
We do not really know what the world would
look like at 5°C above preindustrial times. The
most recent warm period was around 3 million
years ago when the world experienced tempera-
tures 2–3°C higher than today (Eystein Jansen
et al. 2007, 440). Humans (dating from around
100,000 years or so) have not experienced any-
thing that high. Around 10,000–12,000 years
ago, temperatures were around 5°C lower than
today, and ice sheets came down to latitudes just
north of London and just south of New York.
As the ice melted and sea levels rose, England
separated from the continent, rerouting much of
the river flow. These magnitudes of temperature
changes transform the planet.
At an increase of 5°C, most of the world’s ice
and snow would disappear, including major ice
sheets and, probably, the snows and glaciers of
the Himalayas. This would eventually lead to
sea-level rises of 10 meters or more, and would
thoroughly disrupt the flows of the major rivers
from the Himalayas, which serve countries com-
prising around half of the world’s population.
There would be severe torrents in the rainy sea-
son and dry rivers in the dry season. The world
would probably lose more than half its species.
Storms, floods, and droughts would probably be
much more intense than they are today.
Further tipping points could be passed, which
together with accentuated positive feedbacks
could lead to “runaway” further temperature
increase. The last time temperature was in the
region of 5°C above preindustrial times was in
the Eocene period around 35–55 million years
ago. Swampy forests covered much of the world
and there were alligators near the North Pole.
Such changes would fundamentally alter where
and how different species, including humans,
could live. Human life would probably become
difficult or impossible in many regions that are
currently heavily populated, thus necessitating
large population movements, possibly or prob-
ably on a huge scale. History tells us that large
movements of population often bring major con-
flict. And many of the changes would take place
over 100–200 years rather than thousands or
millions of years.
While there is no way that we can be precise
about the magnitude of the effects associated
with temperature increases of this size, it does
seem reasonable to suppose that they would,
in all likelihood, be disastrous. We cannot
obtain plausible predictions by ­ extrapolating
MAY 2008
from “cross-sectional” (Robert Mendelsohn
et al. 2000, 557) comparisons of regions with
current temperature differences of around
5°C—comparisons between, say, Massachusetts
and Florida miss the point. Nor, given the non-
linearities involved, can we extrapolate from
lower temperature increases (say 2°C) concern-
ing which there is more evidence. Most people
contemplating 5°C increases and upward would
surely attach a very substantial weight on keep-
ing the probability of such outcomes down.
From this perspective, an examination of
Table 1 suggests that 550ppm CO2e is an upper
limit to the stabilization levels that should be
contemplated. This level is nevertheless rather
dangerous, with a 7 percent probability of being
above 5°C and a 24 percent probability of being
above 4°C. The move to 650ppm CO2e gives
a leap in probability of being above 4°C to 58
percent, and of being above 5°C to 24 percent.
Further, we should remember that the Hadley
Center probabilities are moderately conserva-
tive—one highly computationally intensive
Monte Carlo estimate of climate sensitivity
found a 4.2 percent probability of temperatures
exceeding 8°C (David Stainforth et al. 2005). A
concentration in the region of 550ppm CO2e is
clearly itself a fairly dangerous place to be and
the danger posed by even higher concentrations
looks unambiguously unacceptable. For this
reason, I find it remarkable that some econo-
mists continue to argue that stabilization levels
around 650ppm CO2e or even higher are pref-
erable to 550ppm, or even optimal (William D.
Nordhaus 2007a, 166; Mendelsohn 2007, 95). It
is important to be clear that the “climate policy
ramp” (Nordhaus 2007b, 687) advocated by
some economists involves a real possibility of
devastating climatic changes.
In thinking about targets for stabilization,
we have to think about more than the even-
tual stocks. We must also consider where we
start; costs of stabilization; and possibilities of
reversal, or backing out, if we subsequently find
ourselves in or approaching very dangerous ter-
ritory. The costs of stabilization depend strongly
on where we start. Starting at 430ppm CO2e, sta-
bilizing at 550ppm CO2e or below would likely
cost around 1 percent of world GDP with good
policy and timely decision making (see Section
IB); for stabilization at 450ppm CO2e, it might
cost 3 or 4 times as much (possibly more). With
bad policy, costs could be still higher. Note that
VOL. 98 NO. 2 richard t. ely lecture
the comparison of costs between 450ppm and
550ppm CO2e illustrates the cost of delay —
waiting for 30 years before strong action would
take us to around 530ppm CO2e, from which
point the cost of stabilizing at 550ppm CO2e
would likely be similar to stabilizing at 450ppm
CO2e starting from now. Under most reasonable
assumptions on growth and discounting, a flow
of 1 percent of GDP for 50–100 years starting
now would be seen as much less costly than a
flow for a similar period of 4 percent or so of
GDP, starting 30 years later.
It can be argued that, at some future point,
we might be able to turn to geoengineering, for
example, firing particles into the atmosphere to
keep out solar energy, analogous to the effect of
major volcanic eruptions in the past. There are,
however, substantial dangers associated with
initiating other effects we do not understand.
We might well be replacing one severe risk with
another; however, extreme circumstances could
require an extreme response. And there are dif-
ficult issues of global governance—would it be
right for just one country, or group of countries, to
do this? It seems much more sensible, at accept-
able cost, to avoid getting into this position.
The above is basically the risk-management
economics of climate change. For an expendi-
ture of around 1 percent (between 21 percent
and 3 percent) of world GDP (see Section IB),
we could keep concentration levels well below
550ppm CO2e and ideally below 500ppm CO2e.
While leaving the world vulnerable, this would
avoid the reckless risks implied by the higher
stabilization concentrations (e.g., 650ppm CO2e)
advocated by some economists. Thinking about
the information basis for this argument also
points to caution. If (as is unlikely) the risks of
high concentrations turn out to be low and we
have taken action, we would still have purchased
a cleaner, more biodiverse, and more attractive
world, at modest cost. If our actions are weak
and the central scientific estimates are correct,
we will be in very dangerous circumstances
from which it may be impossible, or very costly,
to recover.

There would be some negatives (more inflexible
equipment in place) and some positives (more technical
knowledge).

B. Costs of Abatement and Prices of GHGs
To this point, our discussion of targets has
focused on those for the stabilization of stocks.
We must now ask about implications for emis-
sions paths and how much, with good policy,
they would cost. We have already anticipated
part of the broad answer—around 1 percent of
world GDP per annum to get below 550ppm
CO2e—but we must look at the argument in a
little more detail.
Figure 2 illustrates possible paths for stabi-
lization at 550ppm CO2e (thin line), 500ppm
CO2e (dotted) and 450ppm CO2e (dot-dashed);
the solid line is BAU. There are many paths for
stabilization at a given level—see, for example,
Stern Review Figure 8.2 (Stern 2007, 226)—but
all of them are a similar shape to those shown (if
a path peaks later it has to fall faster). And if the
carbon cycle weakens, the cuts would have to be
larger to achieve stabilization at a given level—
see Stern Review Figure 8.1 (Stern 2007, 222).
Broadly speaking, however, a path stabilizing at
550ppm CO2e or below will have to show emis-
sions peaking in the next 20 years. For lower
stabilization levels, the peak will have to be
sooner. The magnitudes of the implied reduc-
tions between 2000 and 2050 are around 30 per-
cent for 550ppm CO2e, 50 percent for 500ppm
CO2e, and 70 percent for 450ppm CO2e. Cuts
relative to BAU are indicated in the figure.
Figure 3 shows that, to achieve these cuts in
emissions, it will be necessary to take action
across the board and not in just two or three sec-
tors such as power and transport. For the world
as a whole, energy emissions represent around
two-thirds of the total, and nonenergy around
one-third. Land use change, mainly deforesta-
tion and degradation of forests, accounts for
nearly 20 percent of the total. Given that the
world economy is likely to be perhaps three
times bigger in mid-century than it is now, abso-
lute cuts of around 50 percent would require
cuts of 80–85 percent in emissions per unit of
output. Further, since emissions from some sec-
tors (in particular agriculture) will be difficult to
cut back to anything like this extent, and since
richer countries should make much bigger pro-
portional reductions than poor countries (see
Section IV), richer countries will need to have
close-to-zero emissions in power (electricity) and
transport by 2050. Close-to-zero emissions in
power are indeed possible and this would enable
 AEA PAPERS AND PROCEEDINGS MAY 2008



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Figure 2. BAU and Stabilization Trajectories for 450–550ppm CO2e

Source: Stern Review, Figure 8.4 (Stern 2007, 233).

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Figure 3. Reducing Emissions Requires Action across Many Sectors

Source: Stern 2007, 196.

close-to-zero emissions for much of transport. way of life to the extent of that brought by elec-
This would, however, require radical changes tricity, rail, automobiles, or the Internet.
to the source and use of energy, including much On the path for stabilization there would
greater energy efficiency. Achieving the neces- be different options for cutting emissions that
sary reductions would also require an end to would be more prominent at different times. In
deforestation. The totality of such reductions the earlier periods, there would be greater scope
would, however, not result in a radical change in for energy efficiency and halting deforestation,
VOL. 98 NO. 2 richard t. ely lecture
and with technical progress there will be, and
already are, strong roles for different technolo-
gies in power and transport.
Various different options for abatement were
discussed in Chapter 9 of the Stern Review.
McKinsey has recently carried out a more
detailed study (Per-Anders Enkvist, Tomas
Nauclér, and Jerker Rosander 2007)—see Figure
4. There are several important lessons from this
type of curve. First, there are many options for
reducing emissions that have negative cost; that
is, they save money. Second, there is a whole
range of options and each should be explored in
detail—for example, the costs associated with
combating deforestation in the McKinsey curve
are, in my view, far too high. Third, the emis-
sions savings from any one option will depend
on what it replaces. Fourth, given the broad
range of options, policy is very important—bad
policy will lead to the uptake of more expensive
options. Fifth, technical progress will be impor-
tant and should be promoted so that the range
of options is widened and costs are reduced.
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 meas-
ured, lower-cost approach. Going more slowly
and then moving in haste when and if the sci-
ence is confirmed still more strongly, is likely to
be the expensive option.
Very importantly for policy, this type of fig-
ure gives us an understanding of where carbon
prices (or GHG prices more generally) should
be. By 2030, cuts at the world level would have
to be of the order of 20 Gt CO2e (see Figure 2)
for stabilization at 550ppm CO2e. This suggests
a CO2 price of around €30 per ton.
A fairly clear idea of where the carbon price
should be from the point of view of necessary
abatement is of great help both to policymakers
and to investors. It also provides the opportu-
nity to check against estimates of the ­marginal

Illustrative MAC curves were provided in the Stern
Review, Figures 9.1 (Stern 2007, 243) and 9.2 (Stern 2007,
249).

Erin C. Myers (2007, 9–12) reviews the literature and
highlights the outlier status of the McKinsey deforestation
estimate; see also the discussion in Section IV.

This is not the place to speculate about euro-dollar
exchange rates over two or three decades.

social cost of carbon (SCC) reflecting the
future damage of an incremental emission. The
­levels quoted here for the MAC are consistent
with ranges for the SCC indicated in the Stern
Review along an abatement path for 550ppm
CO2e stabilization.
However, the SCC is very slippery numeri-
cally since it is so sensitive to assumptions
about model structure, including future emis-
sion paths, carbon cycles, climate sensitivity,
future technologies, and ethical approaches to
valuation over the centuries to come. The SCC
at time t is the expectation of the integral over t
from t onward of:
• the marginal social utility of consumption at
t (embodying ethical values and a particular
path)
3 the impact on consumption at t of all rel-
evant preceding temperature changes (and
resultant climate change)
3 the impact on a relevant temperature
increase of increases in preceding carbon
stocks
3 the impact on all relevant stocks of an
increase in carbon emissions at t, where
“impact” in the above is to be interpreted
as a partial derivative.
Given this sensitivity, it is remarkable how
carelessly the SCC is often quoted—it is quite
common, for example, for people to quote an
SCC without even referring to a reference emis-
sions path, to say nothing of all the other rel-
evant assumptions that matter greatly.
Thus, the SCC is a very weak foundation for
policy. The target approach and the calculation
of the associated MAC is more attractive from
the point of view both of policy toward risk and
of clarity of conclusions. It is also important,
however, to check prices derived from the MAC
against SCC calculations and to keep policy
under revision, as further information and dis-
covery arrives. Some notion of the SCC is also
useful in examining the emissions savings from,

This sketch of the calculation assumes the simple
objective of the maximization of the integral of expected
utility.
10 AEA PAPERS AND PROCEEDINGS MAY 2008



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Figure 4. McKinsey Bottom-Up Approach to Abatement Costs

Source: Enkvist et al. 2007, 38.

for example, transport programs or policies. If The Stern Review (Chapter 10) also looked
the MAC and SCC were thought to be in very at top-down macro modelling of costs of
different ball parks for an anticipated path, it emissions reductions (see also Terry Barker,
would suggest strongly that policy revision is Mahvash Saeed Qureshi, and Jonathan Köhler
necessary. 2006). Both the bottom-up (Chapter 9) and
Prices for abatement should be at a level that the top-down (Chapter 10) studies produced
supports carbon capture and storage (CCS) for numbers in similar ranges—around 1 percent
coal. Without CCS for coal it will be difficult of world GDP. There is, of course, consider-
(and more costly) to achieve the necessary cuts, able uncertainty. Bad policy or delayed deci-
given that many countries will rely heavily on sions could give higher numbers. Stronger
coal for power generation for the next 30 or technical progress could give lower numbers.
40 years (IEA 2006; 2007). China and India Assumptions about ­substitutability between dif-
(Expert Committee on Integrated Energy Policy ferent goods and options matter, too. Since the
(ECIEP) 2006), for example, will be using coal Stern Review was published, there have been
for around 80 percent of their electricity plants a number of new studies, both bottom-up and
for the next 30 years or so—for the simple rea- top-down. Significant examples of the former
sons that coal is cheap and available within their are those from McKinsey (Enkvist, Nauclér,
own borders; that they are familiar with the and Rosander 2007) and the IEA (2007), both
technologies; and that the plants can be erected of which indicated costs either in the region we
quickly. Speed is of great importance for them, suggested, or somewhat lower. Similar conclu-
as the costs of electricity outages are very high. sions are drawn in the AR4 (IPCC 2007).
VOL. 98 NO. 2 richard t. ely lecture
It is very important to recognize that costs
of 1 percent of GDP do not necessarily slow
medium- or long-term growth rates. They are
like a one-off 1 percent increase in prices from
“doing energy” in different ways. Further, there
is a real possibility that incentives to discov-
ery could generate a Schumpeterian burst of
growth—on such possibilities see recent work
by Philippe Aghion (2007). The scale of markets
for new technologies will be very large (IEA
2006); see also Samuel Fankhauser, Friedel
Sehlleier, and Stern (2007) for an assessment
of investment and employment opportunities,
which are likely to be positive.10
Finally, reducing GHGs can bring strong
benefits elsewhere. Cleaner energy can provide
greater energy security and energy access. It can
give reductions in local air pollution. Cleaner
transport policies can increase life expectancy.
Combating deforestation can protect watersheds,
sustain biodiversity, and promote local liveli-
hoods. Taking these associated benefits into
account would reduce cost estimates further.
In summary, looking back after a year, we
would suggest that subsequent evidence and
analysis have confirmed the range of our cost
estimates for stabilization, or indicated that they
may be on the high side. Good policy and timely
decision making are, however, crucial to keep-
ing costs down. And we would emphasize that
taking a clear view now of a stabilization goal
allows for a measured and careful adjustment,
allowing for the replacement cycles of capital
goods. To wait and see, or to rely on a “cli-
mate policy ramp,” risks not only excessive and
dangerous levels of stocks but also much more
costly abatement if, as is likely, there is a sub-
sequent realization that the response has been
delayed and inadequate.
II.  Stabilization of Stocks of   methods, providing tools for analysis of big
Greenhouse Gases II:  changes in, say, one or two markets as a result of
Modelling and Evaluation of Damages
A. Introduction
The previous section looked directly at the
risks from GHGs, and at the costs of action to
10
These assessments refer to the potential shifts of
the demand side of labor markets—outcomes depend, of
course, on market structures.
11
reduce emissions, and thus risks. This is the
kind of judgement that people take when con-
sidering various forms of insurance, or design
of buildings or infrastructure, or new medical
treatments. They try to be as clear as possible
on consequences and costs, bearing in mind
that both are stochastic and that risk is of the
essence, while also being aware that it will often
be difficult to put a price or money values on
consequences and risks.
It is also informative, however, to try to pro-
duce, using aggregate models, quantitative esti-
mates of avoided damages in order to compare
with costs. For climate change, that quantifi-
cation may be possible for some dimensions,
for some locations, for some time periods, and
for some ranges of temperature increases.11
However, the avoidance of planet-transform-
ing change by keeping down risks of 5°C and
above is at the heart of the argument here and it
is extremely difficult to provide plausible aggre-
gate numbers for the effects and overall dam-
ages of temperatures so far out of experience,
particularly when nonlinearities may be of great
importance. Nevertheless, formal modelling is
central to the tools of our trade and the exercises
do have value in bringing out the logic of some
important trade-offs.
In making valuations of consequences, we
have to face very difficult analytical and ethical
issues. How does one value the transformation of
the planet, the consequences of radical changes
in ways of life, and big movements of population
and associated conflict? Our standard cost-ben-
efit analysis (CBA) tools do not give us much
guidance. I have invested a lot of effort (e.g.,
Jean P. Drèze and Stern 1987, 1990), as have
many others, in developing these tools, and have
some understanding of what they are and where
they can be applied. They are largely marginal
a program. But when we are considering major
strategic decisions for the world as a whole, with
huge dynamic uncertainties and feedbacks, the
potential contribution of an approach to decision
making based on marginal methods is very lim-
ited. Rational decision making has to go back
to the first principles from which the marginal
11
See, for example, Chapters 1, 3, 4 and 5 of the Stern
Review.
12 AEA PAPERS AND PROCEEDINGS
methods of CBA are derived. This is not at all
to use a different theory. On the contrary, it is to
maintain the theory and to avoid a gross misap-
plication of the special (i.e., marginal) case.
The centrality of nonmarginal changes and
of risk means either using the risk-analysis
approach of Section IA, or using aggregate mod-
elling with a social welfare function to compare
consequences. Both have their role, but for the
reasons given I would see the former as the main
plank of the argument. The latter has a valuable
supplementary role which we now investigate.
In setting out a social welfare function to
evaluate damages and costs, the valuation of
consequences on different dimensions—social,
health, conflict, and so on—will be extremely
difficult. I do not go into these issues. I focus
on one issue that has, understandably, received
considerable attention in discussion of the Stern
Review—how to value benefits accruing to dif-
ferent people at different times. There are una-
voidable ethical issues. They are the subject of
Section IIB. In Section IIC we examine some of
the challenges, results, and sensitivities of for-
mal modelling, and comment on new evidence
and discussions concerning the Stern Review’s
damage estimates after one year.
B. Ethics
Discounting.—Much of the discussion of
ethics in relation to the Stern Review has been
focused on discounting. Sometimes, simplistic
approaches to discounting conceal or obscure
the underlying structural and ethical logic by
shoehorning the issues into a simple discount
rate specified entirely externally to the problem.
However, careful use of theory and concepts is
crucial. Some have argued that “the discount
rate of the Stern model” is too low in relation to
market rates of return. This argument has gener-
ally been thoroughly confused for a whole set of
reasons. It arises from inappropriate application
of a marginal method to a strongly nonmarginal
context, failure to apply modern public econom-
ics, ignorance of the multi-good nature of this
problem, and, in some cases, ignorance of the
difference between a social discount rate and
a pure time discount rate. Given this pervasive
confusion about the basic theory of discounting,
it seems worthwhile to clarify briefly the logic
of discounting as applied to climate change and
relate it to some simple empirical data.
MAY 2008
Let us start with the definition of a discount
rate in policy evaluations. It is simply the propor-
tionate rate of fall of the value of the numeraire
used in the policy evaluation. In the simple case,
with aggregate consumption as the numeraire,
we have a social discount factor or SDF, l 1t 2 ,
which measures the social value of a unit of con-
sumption at time t relative to a unit at time zero.
·  
The social discount rate, or SDR, is then 2l /l.
A number of general conclusions follow
immediately from these basic definitions. First,
the SDF and the SDR depend on a given refer-
ence path for future growth in consumption and
will be different for different paths. Second, the
discount rate will vary over time. Third, with
uncertainty, there will be a different discount
rate for each possible sequence of outcomes.
Fourth, there will be a different discount rate
for different choices of numeraire. In imperfect
economies, the social value of a unit of private
consumption may be different from the social
value of a unit of private investment, which may
be different from the social value of a unit of
public investment. And the rates of changes of
these values may be different too.
A further key element for understanding dis-
count rates is the notion of optimality of invest-
ments and decisions. For each capital good, if
resources can be allocated without constraint
between consuming the good in question and its
use in accumulation, we have, for that good, the
result that the social rate of return on investment
(the marginal productivity of this type of good
at shadow prices), the SRI, should be equal to
the SDR in terms of that good (i.e., with that
good as numeraire). This is intuitively clear and
in optimal growth theory is a standard first-
order condition. But where there are constraints
on this optimization, as there usually will be
in imperfect economies, this condition that the
SRI equal the SDR is not generally applicable.
Drèze and Stern (1987, 1990), for example, show
how opportunity costs, and thus shadow prices
and shadow rates of return, depend on which
alternative use a unit of resource comes from.
Further, in such economies it will not generally
be true that the private rate of return on invest-
ment (PRI) will be equal to the SRI. And simi-
larly, private discount rates (PDRs) can diverge
from SDRs. Such divergences can arise from all
forms of market imperfections, including exter-
nalities. In this case we have the additional com-
plication that key players, future ­ generations,
VOL. 98 NO. 2 richard t. ely lecture
are not directly represented. Thus, in the general
case:
PDR Z SDR Z SRI Z PRI.
Before looking into discount rates along a
given path, we should remind ourselves that the
most basic mistake here is to use a marginal
concept (discount rates) around a current path
for strategic choices and comparisons among
paths. Policy on climate change means choosing
among paths with very different growth patterns
for a whole collection of capital goods, includ-
ing those relating to natural endowments. Thus,
it is simply wrong to look at rates as currently
observed, or in historical terms, which refer to
existing paths. A choice among paths means
also choosing the implied set of discount rates
associated with the paths (Stern 2007, 27–31;
for more on this issue see Cameron Hepburn
2006). This is simply another way of expressing
the old idea that the shadow prices or marginal
values depend on where you are. It is absolutely
fundamental here for this very nonmarginal set
of choices to recognize that the social discount
rates are endogenous, not exogenous. They are
determined by ethical values, which have to be
discussed explicitly, and by the paths that result
from climate change and investment choices.
Let us suppose, however, that we go past this
problem and look at discount rates around a
given path, or path of choice. What can we learn
from observed rates in markets? Rates at which
households can borrow and lend, usually for
periods of no longer than three or four decades,
give a reading on their private discount rates or
PDRs (assuming they equate their discount rate
with their market rate, with some appropriate
treatment of uncertainty). But as this borrowing
and lending takes place through private deci-
sions made by individuals acting in a market,
this does not necessarily answer the relevant
question in the context of climate change deci-
sions by a society—namely, how do we, acting
together, evaluate our responsibilities to future
generations over very long periods?
Rates of return on investment generally reflect
private rates of return narrowly measured. They
take no account of externalities, which are of
the essence for this discussion. Thus, even if
we think we can observe some private rates of
discount for some households, and some pri-
vate rates of return for some firms, we do not
13
have a reading on the concept at issue here, the
social discount rates for the key goods. Thus,
observations on the PRIs and PDRs have only
limited usefulness. And note that the problems
that prevent the equalities in this chain, such
as missing markets, unrepresented consumers,
imperfect information, uncertainty, production,
and consumption externalities are all absolutely
central for policy toward the problem of climate
change. We come back again to a basic con-
clusion: the notions of ethics, with the choice
of paths, together determine endogenously the
discount rates. There is no market-determined
rate that we can read off to sidestep an ethical
discussion.
It must surely, then, be clear that it is a seri-
ous mistake to argue that the SDR should be
anchored by importing one of the many private
rates of return on the markets (or a rate from
government manuals, or a rate from outside
empirical studies). Yet it is a mistake that many
in the literature have made. Nordhaus (2007b,
690) and Martin L. Weitzman (2007b), for
example, substitute a market investment return
of 6 percent for the SDR, thus producing a rela-
tively high 6 percent rate of discount on future
consumption. This mistakenly equates the
PRI to the SRI and the SRI to the SDR. Such
an approach is entirely inappropriate given
the type of nonmarginal choices at issue and
the risk structure of the problem, and in light
of developments in modern public economics,
which encompasses social cost-benefit analysis
and which takes account of many imperfections
in the economy, including unrepresented con-
sumers, imperfect information, the absence of
first-best taxes, and so on.
If, despite these difficulties, we nevertheless
insist on looking to markets for a benchmark rate
of discount, then what do we find? In the United
Kingdom and United States, we find (relatively)
“riskless,” indexed lending rates on government
bonds centered around 1.5 percent over very long
periods. For private very long-run rates of return
on equities, we find rates centered around 6 or 7
percent (Rajnish Mehra and Edward C. Prescott
2003, 892; Kenneth J. Arrow et al. 2004, 156;
Sree Kochugovindan and Roland Nilsson 2007a,
64; 2007b, 71). Given that it is social discount
rates that are at issue, and also that actions to
reduce carbon are likely to be financed via the
diversion of resources from consumption (via
pricing) rather than from investment, it is the
14 AEA PAPERS AND PROCEEDINGS
long-run riskless rates associated with consumer
decisions that have more relevance than those
for the investment-related equities. Thus, even
if one were to endorse the approach of import-
ing a discount rate from markets, when one uses
the rate of return closer (but not equivalent) to
the relevant concept—the risk-free rate—it is
far from clear that one would obtain a rate of
discount on future consumption as high as the 6
percent advocated by Nordhaus (2007b, 690).
Weitzman (2007c) has recently produced an
interesting insight into the difference between
the riskless rate and equity returns in terms of
perceived high weights in the downside tail of
equity returns—the implication being that the
perceived equivalent return on equities, allow-
ing for risk, is close to the lower riskless rates.
In this context Weitzman (2007a, b), has also
suggested encapsulating risk and uncertainty in
some contexts into discount rates. In my view,
however, it is far more transparent to treat risk
directly through the approach to social welfare
under uncertainty than to squash it into a single
parameter that tries to reduce the problem to one
of certainty.
Suppose, however, that we persisted with
the argument that it is better to invest at 6–7
percent and then spend money on overcom-
ing the problems of climate change later rather
than spending money now on these problems.
The multi-good nature of the problem, together
with the irreversibilities from GHG accumula-
tion and climate change, tell us that we would
be making an additional mistake. The price of
environmental goods will likely have gone up
very sharply, so that our returns from the stand-
ard types of investment will buy us much less in
reducing environmental damage than resources
allocated now (see also Section I on the costs
of delay).12 This reflects the result that if envi-
ronmental services are declining as stocks of
the environment are depleted, then the SDR
with that good as numeraire will be negative.
On this, see the interesting work by Michael
Hoel and Thomas Sterner (2007), Sterner and
U. Martin Persson (2007) and Roger Guesnerie
12
The issue is still more complex in this context, as
delays in action result in environmental damage along the
way, as well as increasing the cost of achieving a given sta-
bilization level. On balance, the extra intertemporal com-
plexity is likely to strengthen this paper’s argument in this
case.
MAY 2008
(2004), and also the Stern Review (Stern 2007,
60). Environmental services are also likely to
be income elastic, which will further reduce the
implied SDR.
Finally, we underline an unhappily common
mistake—namely confusing the pure time dis-
count rate (PTDR) with the SDR. With a very
simple single good structure and consumption
at time t having social value u 1c 2 e2dt, we have
the SDF, l, as u91c 2 e2dt.13 Its proportionate rate
of fall (the SDR) is h 1c· /c 2 1 d, where h is the
elasticity of the social marginal utility of con-
sumption with respect to consumption.14 Often
h is taken to be a constant. In this very simple
case, we can now see the difference between the
SDR and the PTDR. The PTDR is the rate of
fall of the value of a unit of consumption, simply
because it is in the future, quite separately from
the levels of consumption enjoyed at the time.
Here, the PTDR is d. For example with d 5 0,
h 5 1.5, and c· /c 5 2.5 percent, we have a social
discount rate of 3.75 percent, in excess of the UK
government’s test discount rate (Her Majesty’s
Treasury 2003), notwithstanding a PTDR of
zero. It is h and the growth rate that capture the
idea that we should discount the consumption
of future generations on the basis that they are
likely to be richer than ourselves. This reason
for discounting is, and should be, part of most
models, including those of the Stern Review. We
shall show in the next subsection that the cost,
in terms of climate changes, of weak or delayed
action in the formal models is much greater than
that of timely and stronger action, in terms of
abatement expenditure, over a range of param-
eter values for h.
A d of 2 percent (3 percent)—as endorsed by
many commentators such as Nordhaus (2007b)
13
The SDF is the marginal utility of consumption at
time t (and we normalize the SDF to one for t 5 0). If we
consider a changing population N 1t 2 , and replace u 1c 2 by
Nu 1c 2 where c is C/N and C is total consumption at time t,
the partial derivative with respect to C is u91c 2.
14
Unfortunately, some, including Nordhaus (2007b)
and Weitzman (2007b), have been tempted to think that a
value for the PTDR can be “backed out” from this expres-
sion by equating the SDR with some market rate of return.
For example, with a market investment return of 6 percent,
consumption growth of 2 percent, and h 5 2, one “infers”
that d 5 2 percent. Thus, the fallacy that the SDR can be
anchored by some market rate of return leads to a second
fallacy, namely that society’s PTDR can be “revealed” from
market behavior (instead of requiring explicit specification
on ethical grounds).
VOL. 98 NO. 2 richard t. ely lecture
and Weitzman (2007b)—implies that the util-
ity of a person born in 1995 (1985) would be
“worth” (have a social weight) roughly half that
of a person born in 1960. This type of discrimi-
nation seems very hard to justify as an ethical
proposition and would be unappealing to many.
Indeed, the ethical proposition that d should be
very small or zero has appealed to a long line
of illustrious economists including Frank P.
Ramsey (1928, 543), Arthur Cecil Pigou (1932,
24–5), Roy F. Harrod (1948, 37–40), Robert M.
Solow (1974, 9), James A. Mirrlees (Mirrlees and
Stern 1972), and Amartya Sen (Sudhir Anand
and Sen 2000). I have heard only one ethical
argument for positive d (Wilfred Beckerman
and Hepburn 2007; Simon Dietz, Hepburn, and
Stern 2008) that has some traction—namely a
temporal interpretation of the idea that one will
have stronger fellow feelings for those closer
to us (such as family or clan) relative to those
more distant. This is often explained in terms
of functionality for survival of groups. However,
this type of reasoning from evolutionary biol-
ogy does not have much relevance when we are
thinking about the survival of the planet as a
whole.
For these reasons, the Stern Review followed
the tradition established by the economists cited
above, adopting and arguing strongly for a d
that exceeds zero only in order to account for
the possibility of some exogenous event that
would render future welfare calculations irrele-
vant—the exogenous extinction of humanity (for
discussion of this interpretation of d, see, e.g.,
David Pearce and David Ulph (1995) and David
Newbery (1992)). On this basis, the Review
adopted a d of 0.1 percent (although even this
value for d appears to be quite large in relation
to this interpretation, implying a probability of
exogenous extinction of around 10 percent in 100
years). For a project or program, the probability
of exogenous extinction could be substantially
higher, and this is reflected in some cost-benefit
manuals or approaches; in our case, however, we
are considering humanity as a whole.
My overall assessment of the discussion of
discounting in the context of climate change is
that it is disappointing. All too often it has failed
to come to grips with the basic concepts, with
the key nonmarginal and uncertainty elements
at the core of the issue, and with the theories of
social cost-benefit analysis and modern public
economics of the last 30 or 40 years.
15
Distributional Judgements.—Having seen
the implausibility of importing a discount rate
from outside the model to sidestep ethical judge-
ments, let us turn to the ethics relating to the
distribution of consumption or income, at least
in its very narrow form of h within the narrower
cases (as in the models that follow) where the
gral of g i u 1ci 2 e2dt (Stern 2007, 50–54).15
social objective is the expectation of the inte-
Thinking about h is, of course, thinking about
value judgements—it is a prescriptive and not
a descriptive exercise. But that does not mean
that h is arbitrary; we can, and should, ask
about “thought experiments” and observations
that might inform a choice of h. In so doing we
must remember that h plays three roles, guiding
(a) intratemporal distribution, (b) intertemporal
distribution, and (c) attitudes to risks. We look
at the relevance of empirical data for each of the
three in turn.
Intratemporal Distribution: Let us begin
with a thought experiment concerning direct
consumption transfers in a very simple con-
text. If A has k times the consumption of B, the
social value of a unit of consumption to B is kh
times that to A for constant h. For example, for
k 5 5 and h 5 2, the relative value is 25 and a
transfer from A to B would be socially worth-
while even if up to 96 percent were lost along
the way (the so-called “leaky bucket”—Arthur
M. Okun (1975)). While I might not regard that
position as unacceptable, to take just one exam-
ple, it appears inconsistent with many attitudes
to transfers. In this sense, many would consider
an h of 2 to be very egalitarian. With h 5 1,
the 96 percent in the example above becomes 80
percent because the unit to B is worth five times
that to A. Some might regard even this position
as rather egalitarian.
Value judgements are, of course, precisely
that and there will be many different positions.
They will inevitably be important in this con-
text—they must be discussed explicitly and
the implications of different values should be
examined. Examples follow of what we find
when we turn to empirical evidence and try to
obtain implied values (the “inverse optimum”
approach). Empirical evidence can inform, but
15
The summation is across individuals existing at time t
and ci is the consumption of individual i.
16 AEA PAPERS AND PROCEEDINGS
not settle, discussions about value judgements—
for further exploration see Dietz, Hepburn, and
Stern (2008). In using such evidence, we must
constantly bear in mind two key issues. First, we
must ask about the relevance of individual deci-
sions for the societal decisions about the prob-
lem at hand—here social decisions by the world
community now, bearing in mind consequences
for future generations. And, second, if we infer
values from decisions, we must ask whether we
have modelled well the decision processes, the
objectives, and the perceived structure of the
problem as seen by the decision maker.
Anthony B. Atkinson and Andrea Brandolini
(2007) have produced an interesting set of
examples on empirical income distributions and
actual transfer schemes in relation to welfare
weights.16 They conclude that constancy of h
across a range of increases is difficult to “square
with” the way that many transfer schemes occur
in practice; in addition, there are many exam-
ples where policies appear inconsistent with h
greater than one. For example, given the cur-
rent income distribution in the United States,
an h of two would imply that a redistribution
from the fifth-richest decile to the second-poor-
est decile would be welfare-improving even if
only 7 percent of the transfer reached the recipi-
ent; for a transfer from the richest decile to the
second-poorest, virtually any redistribution
would be welfare-improving regardless of loss
along the way, so long as the recipient received
some benefit (Atkinson and Brandolini 2007,
14). Of course, interpretation of actual intratem-
poral tax and transfer schemes will depend on
many assumptions about the structure of incen-
tives17 and policymaking procedures. Perhaps
people think that tax-transfer disincentives are
very strong and they oppose transfers for these
reasons. Or notions of rights and duties may
influence them. The upshot is that empirical
estimates of implied welfare weights can give a
wide range of h, including h below one and even
as little as zero.
16
The welfare weight on an individual with consump-
tion c is taken here as the social marginal utility of con-
sumption at that level. To keep things simple, we assume
that this depends only on the individual’s consumption and
not on her preceding consumption or the consumption of
others.
17
See, for example, Stern (1976), who shows how sensi-
tive tax calculations are to assumptions about substitutabil-
ity between goods and leisure.
MAY 2008
It is striking that there are some, such as
Nordhaus (2007b) and Weitzman (2007b), who
appear to argue for high h (equal to 2 or 3) in
intertemporal analysis yet do not bring out how
this is potentially inconsistent with standard
cost-benefit analysis treatments of intragen-
erational distribution (which effectively assume
h 5 0) or with some intratemporal tax and trans-
fer policies.
Intertemporal Distribution: In discussions
of h in an intertemporal framework, there has
been much focus on implied saving rates. Some
(Partha Dasgupta 2007, 6; Nordhaus 2007b,
694–96), following arguments in Kenneth J.
Arrow (1995, 12–17), have criticized the rela-
tively high weight placed by the Stern Review on
the consumption of future generations (whether
via h or d) by arguing that the Review’s param-
eter choices can, in certain scenarios, imply
implausibly high optimal savings rates. As is
clearly explained in the Review (Stern 2007,
54), with d 5 0, output proportional to capital,
and no technical progress, the optimal savings
rate is 1/h. With h close to one, this would lead
to very high optimal savings rates. At the same
time, the Review also states clearly (Stern 2007,
54) that this result is highly dependent on model
assumptions.
Brad DeLong, in a short blog entry (DeLong
2006), points out this flaw in the Dasgupta-
Nordhaus position and argues that techni-
cal progress would greatly reduce the optimal
­savings rate. Mirrlees and Stern (1972) ­presented
a more fully developed argument. Using a
standard one-good, infinite-horizon Ramsey
growth model, constant returns to scale, and a
Cobb-Douglas production function, they show
that under one specification—with constant
population, a competitive share of capital equal
to 0.375, and 3 percent exogenous technologi-
cal progress—the optimal consumption path
for h 5 2 and d 5 0 involves a savings rate, s,
between 0.19 and 0.29 (or 0.23 if constrained to
a constant s). This is far below the 0.5 that would
be optimal with h 5 2 and d 5 0 in the simpler
case of output proportional to capital and no
technical progress.
Just as with intragenerational values, the
approach of the “inverse optimum” or implied
social values does not take us very far in this
context. We cannot really interpret actual sav-
ing decisions as revealing the collective view
VOL. 98 NO. 2 richard t. ely lecture
of how society acting together should see its
responsibilities to the future in terms of distri-
butional values—too much depends on assump-
tions about how decisions are made in a society
and on how the participants perceive the work-
ings of the future economy. Observed aggregate
savings rates are sums of individual decisions,
each taken from a narrow perspective. This is
not the same thing as a society trying to work
out responsible and ethical collective action—
the crucial issue for climate change.
Attitudes to Risks: “Guidance” on h from
analyses of risk and uncertainty is even less
informative. We can interpret h as the param-
eter of relative risk aversion in the context of an
expected utility model of individual behavior.
However, the expected utility model is unreliable
as a description of attitudes to risk. Further, we
see a whole range of behavior, from the accep-
tance of “unfair risks” in gambling 1similar to h
, 02 to extreme risk aversion in insurance 1very
high h 2. And even if behavior were somewhat
more “rational” in the narrow sense of conform-
ing to the expected utility hypothesis, it would
still be unclear how sound a basis it would be for
the specification of a prescriptive value for use
in this context.
From this very brief discussion of empirical
information, which might help us to think about
h in a prescriptive context, our conclusion is that
there is very little to guide us.18 Again, we are
pushed back to the standard moral philosopher’s
approach of trying to think through simple
examples, i.e., the thought experiment. It has the
great virtue of facing the issues directly—it is
transparent and clear.
What do we conclude about ethics and dis-
counting in this context when we clear the vari-
ous confusions out of the way? The answer is
fairly simple. First, we must address the ethics
directly. There is no simple market information
from intertemporal choices or otherwise that can
give us the answers. Second, if we express the
problem in standard welfare economic terms,
i.e., portray the objective as an expectation of an
integral of social utility, we cannot use marginal
approximations to changes in welfare since we
18
Thirty years ago (Stern 1977), I examined all three
of these methods with no particularly strong conclusions,
other than that the results covered a broad range.
17
are comparing strategies that yield very differ-
ent paths. Third, within this framework we may
focus the discussion on elasticities of marginal
social utility h and pure time discount rates d,
but in so doing we must recognize the ethical
narrowness of this approach. Fourth, direct ethi-
cal discussion of h and d suggests a broad range
for h, although the consequences for simple
transfers suggest that many would regard h in
excess of 2 as unacceptably egalitarian; on the
other hand, there appears to be little in the way
of ethical arguments to support d much above
zero. Fifth, within a marginal analysis frame-
work, the relevant concept for discounting here
is the SDR. In the narrow h–d context, with h
of 1 to 2, very low d, and growth at 1.5–2.5 per-
cent,19 we find an SDR of 1.5–5 percent, which
is close to ranges for long-run consumer real
borrowing rates and (at least in the UK) govern-
ment discount rates for program evaluations.
C. Formal Modelling
Aggregate models have been popular in the
economics of climate change. They attempt
to integrate the science of climate change, as
expressed, for example, via GCMs, with eco-
nomic modelling and are termed integrated
assessment models, or IAMs.
As I have argued, it is very hard to believe that
models where radically different paths have to
be compared, where time periods of hundreds of
years must be considered, where risk and uncer-
tainty are of the essence, and where many cru-
cial economic, social, and scientific features are
poorly understood, can be used as the main quan-
titative plank in a policy argument. Thus, IAMs,
while imposing some discipline on some aspects
of the argument, risk either confusing the issues
or throwing out crucial features of the problem.
A related but different point is their use,
when modelling of costs of abatement is inte-
grated with modelling of damages from emis-
sions, as vehicles for optimization analysis. In
19
In Section IIC we consider h in this range. Higher
growth rates are not examined in detail. The modelling
would have to take account of a changed path of emissions
with earlier damages. With risk distributions appropriate
to current knowledge, our preliminary findings suggest
that estimated damages from climate change are likely to
be well above the cost of action to drastically reduce those
risks.
18 AEA PAPERS AND PROCEEDINGS
this respect, they are still less credible. Those
of us schooled in the optimal tax and optimal
growth analysis of the 1960s, 1970s, and 1980s
learned just how sensitive model results can
be to simple structural assumptions, such as
the form of preferences, production, or techni-
cal progress, even before parameter values are
introduced (Atkinson and Joseph Stiglitz 1976,
1980; Angus Deaton and Stern 1986).
The models portrayed here should be seen
as helpful supplements exploring some serious
logical and modelling issues related to the esti-
mation of damages from BAU and their com-
parison with alternative paths. We shall see, not
surprisingly, that the key assumptions influenc-
ing damage estimates concern risk and ethics. It
is surprising, however, that these two issues did
not occupy until recently the absolutely central
position that the logic of the analysis demands.
The result is that—given the recent evidence on
emissions, carbon cycles, and climate change
sensitivity—most of the studies prior to a year
or two ago grossly underestimated damages
from BAU.
The PAGE20 model was chosen for the work of
the Stern Review first, because, in contrast with
a large majority of preceding work, it places risk
and uncertainty at center stage. It provides for
a Monte Carlo analysis of explicit distributions
of a large number of parameter values. Second,
Chris Hope, its originator, chose the parameters
and their distributions to straddle a range of cli-
mate models, IAMs, and economic models in
the literature. Third, Chris Hope kindly made
the model available and was very generous with
his advice. The model was described extensively
in Chapter 6 of the Stern Review as well as by
Hope (2006a, b) and Dietz et al. (2007a, b).
Key assumptions on the form of the models
and of the parameters in these models may be
grouped into two broad headings: the structural
elements that shape the estimated consequences
of different kinds of emissions strategies, and
the ethical elements that shape the evaluations
of different outcomes. Of the structural elements
in this approach, four are crucial: the emission
flows; the functioning of the carbon cycle link-
ing flows to stocks; the climate sensitivity link-
ing stocks to temperature; and the ­damages from
20
PAGE 2002, Policy Analysis of the Greenhouse Effect
2002 Integrated Assessment Model, see Hope (2006a, b).
MAY 2008
temperature, via climate change. Of the ethical
elements, the following are crucial: the type of
ethical values considered (including the role of
rights and obligations); the type of outcomes
introduced into evaluation functions (including
separate goods or services such as environment,
health, and standard elements of consumption);
the functional forms used to capture evaluations;
and the parameters within those functional
forms, including those covering intra- and
intergenerational values. The ethical discussion
should not be shoehorned into a narrow focus on
just one or two parameters such as h and d; the
ethical issues and their interactions with a model
structure designed to reflect a range of uncer-
tainties are much broader and deeper.
Stern Review Damages and Sensitivity.—The
Stern Review base case had damages from BAU
relative to no climate change of around 10 per-
cent of consumption per annum measured in
terms of the Balanced Growth Equivalent, or
BGE (see Mirrlees and Stern 1972). Here, the
BGE for any given path is calculated from the
expected social utility integral of that path by
asking “what initial consumption level, growing
at a given growth rate and without uncertainty,
would give this expected social utility inte-
gral?” The difference between the BGEs with
and without climate change can be thought of as
the premium, in terms of a percentage of annual
consumption, that society might be willing to
pay to do away with the risk and uncertain-
ties associated with dangerous climate change.
Essentially, the BAU provides a calibration in
terms of consumption (useful since “expected
integrated utils” are hard to interpret) for the
expected utility integral: it summarizes an aver-
age over time, space, and possible outcomes.
Table 2 presents some of the results of the
PAGE model. The parameter h was discussed
in Section IIB and is the elasticity of the social
marginal utility of consumption where the inte-
grand for expected social utility is the sum over
i of Niu 1Ci /Ni 2 e2dt, and where Ci and Ni are
consumption and population in region i. In the
model, g is the exponent of a power function
linking temperature T to damage through the
function AT g (Stern 2007, 660—the damages
vary by region). Table 2 provides BGE differ-
ences (in percent) across paths without and with
climate change, with a 5–95 percent confidence
interval in brackets. We think of increases in g
VOL. 98 NO. 2 richard t. ely lecture 19

Table 2—Sensitivity of Total Cost of Climate Change to Key Model Assumptions

1Definitions in text2

Damage function Consumption elasticity of social marginal utility 1h 2

  exponent 1g2 1 1.5 2
2 10.4 12.2–22.82 6.0 11.7–14.12 3.3 10.9–7.82
2.5 16.5 13.2–37.82 10.0 12.3–24.52 5.2 11.1–13.22
3 33.3 14.5–73.02 29.3 13.0–57.22 29.1 11.7–35.12

Note: Units are percentage losses in the BGE relative to no climate change (see text for
discussion).
Source: Dietz et al. 2007b.

as capturing increases in the structural risks,21
and of increases in h as capturing increases in
aversion to inequality and risk.
Intuitively, we can think of g as combining
both the relation between temperature and dam-
ages, and the distribution of temperatures aris-
ing from a certain emission path. These are, of
course, distinct effects, but both an increase in
g and a broader distribution for the temperature
(in particular more weight in the upper tail,
either from a weakening in the carbon cycle or
from higher climate sensitivity) has the effect
of producing a higher probability of large dam-
ages. The effects are treated separately in the
Review (Chapter 6 and the Technical Annex to
Postscript), where many more sensitivity results
are given. These two processes (damages and
temperature distributions) can and should be
modelled separately, but here we keep the dis-
cussion and presentation as simple as possible.
While we shall discuss results in terms of
the sensitivity of estimated damages with and
­without climate change, we must emphasize that
stabilization at 550ppm CO2e removes around
90 percent22 of the damages (Stern 2007, 333),
so that we are essentially comparing two strate-
gies, namely BAU and stability below 550ppm
CO2e. A key broad lesson from this type of
modelling is that the costs of stabilizing below
550ppm CO2 e are generally far lower than the
21
To keep things simple, the results in the table have g
fixed—that is, nonstochastic. The Monte Carlo probabili-
ties are therefore generated by the variations in the many
other parameters. In the Postscript to the Review (Stern
2007, 658–71), stochastic g is presented. The base case of
g fixed and equal to 2 in Table 2 corresponds closely to the
base case for stochastic g in Chapter 6 of the Review and
the Technical Annex to Postscript.
22
Measured in terms of BGE.
costs of the damages from climate change that
would thereby be avoided. While the measure-
ment of estimated damages may vary, this key
lesson is robust to parameter changes.
In this type of modeling, results are highly
sensitive to assumptions on both structural risks
and ethics, suggesting that great care should be
exercised in choosing the key parameters. We
can illustrate the importance of these two issues
in terms of both computations in the model and of
general results. Replacing all random variables
in the PAGE model by their modes brings down
the central case of damages from BAU from 10–
11 percent to 3–4 percent.23 Thus, it is wrong
to argue, as Dasgupta (2007) and Nordhaus
(2007b) have, that the Chapter 6 results of the
Stern Review arise solely from assumptions
related to ethics, in particular the use of h 5
1 and, at least in the view of Nordhaus, a low
d. Both risks and ethics are crucial to any seri-
ous assessment of policy toward climate change
and, in particular, assessment of damages from
BAU.
A formal result is provided in Box 1, which
shows that for any given set of structural risks
and a utility function, pure time discounting (a
key element in the ethics) can be set so that the
estimated damages are as small as we please.
Further, for any given pure time discounting,
risks and utility can be set such that damages
are as big as we please.
Recently, in a series of papers (Weitzman
2007a, b), Marty Weitzman has argued that
when we consider how the various different
23
See Dietz et al. (2007a, c). The drop from replacing
all random variables by their means is smaller but still
substantial.
20 AEA PAPERS AND PROCEEDINGS MAY 2008

Role for Both Risk and Ethics

• Write expected utility integral as e0 g 1t 2 f 1t 2 dt, where g 1t 2 5 E 3û 1c 2 4, and û  is

`

the welfare difference without and with climate change; f 1t 2 is the pure time dis-
count factor. g 1t 2 will depend on model structure, policies/path, and shape of u 1c 2.
It is possible that g 1t 2 is infinite for some finite T (see Weitzman 2007a).

• For any given g 1t 2, we can construct f 1t 2 so that e0 g 1t 2 f 1t 2 dt , e for any e .

`

0, i.e., there are arbitrarily small losses from climate change. An example is f 1t 2 K
11/g 1t 2 2 e2dt with d . 1/e.

• For any given f 1t 2, we can construct g 1t 2 so that there are infinite losses from cli-
mate change, i.e., e0 g 1t 2 f 1t 2 dt 5 `. An example is g 1t 2 K 1/f 1t 2.
`

• Clearly, both ethical values and risk play key roles.

Box 1

probability distributions (particularly of climate and damages is an example of Knightian uncer-

sensitivity) that might arise in different models
can or should be combined, there is a convinc-
ing case for strong weights in the tails of overall
temperature and damage distributions. These
can lead to divergent (i.e., infinite) estimates of
expected damages. His arguments are powerful
and persuasive, underlining strongly the crucial
role of risk in this story and raising questions on
the use of the expected utility approach.
It is interesting to note that divergence of inte-
grals can occur in three ways in this expected util-
ity integral: first, via uncertainty, as Weitzman
emphasizes; second, via intra­generational dis-
tribution (for example, this can occur for the
Pareto distribution of income, Christian Kleiber
and Samuel Kotz 2003, 59–106); and third, via
integration over time. Indeed, for h 5 1 and d
5 0, with positive growth the time integral is on
the borderline of convergence (Stern 2007, 58).
Thus, for h 5 1 and d 5 0.1 percent, the bulk
of the changes (in terms of the expected utility
integral)—over 90 percent—occur after 2200.
For h 5 2, the proportion is around 10 percent
and for h 5 1.5 around 30 percent. For some
(e.g., William Cline 2007), this is an argument
for h higher than one, and I have some sympathy
with this view.
Claude Henry (2006; Stern 2007, 38–39) has
argued that our lack of knowledge on which of the
probability distributions to use for ­temperature
tainty, and he shows, using recent mathematics
on how the von Neumann–Morgenstern axi-
oms might be modified, how strong weights are
likely to be (or should be) attached to the worst
outcomes. We might see his approach, together
with that of Marty Weitzman, as a mathematical
embodiment of the precautionary principle.
Other forms of sensitivity are summarized
only briefly here—see the Stern Review for
more details. We comment on some specifics
of a weakening carbon cycle on the structural
side; and pure time preference, intragenerational
issues, and a narrower view of dimensions of
damage on the ethical side. The Stern Review
had a “base climate scenario” (Stern 2007, 175)
which ruled out a weakening carbon cycle and
included only very moderate positive natural
feedbacks. These are known to be possibili-
ties, but are not sufficiently well understood to
enable calibration for most modelling purposes.
A “high-climate scenario” (Stern 2007, 175)
introduced increased changes for the carbon
cycle, covering plant and soil respiration and
possible methane emissions from thawing per-
mafrost, but these effects as modelled now look
fairly small in relation to current scientific con-
cerns. This added a 4 percent extra BGE loss
from BAU relative to no climate change. We
also experimented with higher climate sensi-
tivity—see Box 6.2 of the Review (Stern 2007,
VOL. 98 NO. 2
179)—although we did not publish results. It
seems now that the “high 1” scenario discussed
there may be of real relevance.
The PAGE model used in the Review includes
some damage estimates from nonmarket effects
such as health. If these are removed, the base-
case damage estimates drop from 10 percent to
5 percent. Unsurprisingly, results are sensitive
to pure time discounting. A pure time discount
rate of 1 percent implies, under the extinction
view of discounting, only a 60 percent chance
of the world surviving the next 50 years, which
most would regard as a very pessimistic number.
Nevertheless, as the Review’s Technical Annex
to Postscript shows, even with d 5 1 percent,
damages from BAU are likely to be higher than
the costs of a mitigation strategy that removes
the bulk of the risks.
We did not carry out an examination in the
model of intragenerational issues in any detail,
but comparisons with other studies suggested
that these could add around a quarter or more
to loss estimates (for h around 1), in this case
another 4–5 percent. Starting with the base case
of BGE losses of 10–11 percent, these variations
(25 percent for a narrower view of damages,
14 percent for higher climate response, 14 or 5
percent for intragenerational issues) gave us the
range of 5–20 percent losses per annum from
BAU that has been widely quoted. These are
averages in three senses: over time, over space,
and over possible outcomes.
In Chapter 13 of the Review, different meth-
ods for looking at stabilization are examined,
starting with the bottom-up or risk-evaluation
approach of Chapters 1, 3, 4, and 5 (and Sec­
tion I). The discussion of the top-down damage
modelling approach, used in this section of the
paper and in Chapter 6 of the Review, explains
that the 10–11 percent BAU base-case damage
costs are reduced to around 1 percent for stabi-
lization at 550ppm CO2e (Stern 2007, 333) i.e.,
the cost saving from avoided damages of stabi-
lizing at 550ppm CO2e is 9–10 percent. When
compared with costs of stabilization at 550ppm
CO2e of around 1 percent of world consump-
tion or GDP24 (see Section IB above), this sav-
ing from action represents a very good return.
Even if damages avoided are only 3–4 percent
24
Over time, 1 percent of consumption and 1 percent of
GDP are broadly equivalent.
richard t. ely lecture 21
of world consumption or GDP, stabilizing below
550ppm CO2e is still a good deal. The basic
statement that the costs of strong and timely
action are much less than the costs of weak and
delayed action is very robust. Let us underline
again, however, that the Review gives stronger
weight in terms of space and emphasis to the
bottom-up risk evaluation approach than to the
top-down aggregate modelling approach.
Comparison with Other Modelling of
Damages.—Much of the earlier literature on cli-
mate modelling found damage results that were
lower than the results in the Stern Review.25
Much of this earlier work underestimates BAU
emission flows (see below), suppresses or only
lightly touches on risk, takes an extraordinar-
ily low view of damages from temperature
increases, and embodies very high pure time
discounting with little explicit ethical discussion
as to why (see Section IIB).
As Figure 5 shows, Richard S. J. Tol (2002)
and Nordhaus (Nordhaus and Joseph G. Boyer
2000) essentially suppress uncertainty about
climate sensitivity by using point estimates and
not spreads.26 There are some minor attempts
to “add on” risk, but it is not given the central
role demanded by the science and the econom-
ics. The range covered by PAGE is cautious on
climate sensitivity, using only triangular distri-
butions for its parameters—its full spread from
all Monte Carlo runs is within the IPCC AR4
“likely” (66 percent confidence interval) range.
The Meinshausen (2006) spread covers the 90
percent confidence interval for the full range of
models he surveys, some of which go far higher.
Figure 6 summarizes results by Mendelsohn
(Mendelsohn et al. 2000) and Tol (2002) with
astonishingly low damages of 0–2 percent of
GDP from temperature increases as high as
5–6°C. The Nordhaus and PAGE (Christopher
Hope 2006a) damages in terms of output are
fairly close together, although arguably much
too small in relation to the possible implications
of 5–6°C temperature increases.
These early models have given rise to a pow-
erful and unjustified bias against strong and
timely action on climate change. The question
25
A valuable review can be found in Geoffrey Heal
(2007).
26
Their models (FUND for Tol and DICE/RICE for
Nordhaus) can, however, be used for Monte Carlo studies.
22 AEA PAPERS AND PROCEEDINGS MAY 2008

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Sources: Tol 2002; Nordhaus and Boyer 2000; Hope 2006a; 2006b; IPCC 2007; Meinshausen
2006.

is not so much why the Stern Review’s model- (b) The carbon cycle is likely to weaken as
ling obtained high damages under BAU, as why a result of, for example, the possible col-
the earlier literature made assumptions that give lapse of the Amazon forest at temperature
such low results. increases of above 3–4°C, or the decreas-
ing absorptive capacity of the oceans.
D. Damages and Sensitivity, Further, a thawing of the permafrost is
One Year On from the Review likely to result in strong methane release.

Looking back, I think the Review was (c) The climate sensitivity assumed in the
too cautious on all four of the key structural Review is likely to be conservative (as
­elements: (a) emissions growth, (b) carbon cycle, argued in Section I).
(c) climate sensitivity, and (d) damages from a
given temperature. (d) The damages from given temperature
increases assumed in the Stern Review
(a) The work of Ross Garnaut and his seem very low. The Review’s mean dam-
Commission, working for the new age loss (based on estimates in the eco-
Australian government on climate change, nomic literature) from 5°C was around
is revisiting the emissions scenarios in 5 percent of GDP (Stern 2007, 180). As
the IPCC Special Report on Emissions argued in Section I, a temperature increase
Scenarios or SRES (IPCC 2000). In its of 5°C would most likely result in massive
Chapter 6 model (Stern 2007, 173–88), the movements of population and large-scale
Stern Review used the second highest of conflict.
the four scenarios (called A2). Garnaut is
now suggesting that the highest of the four, Considering these structural factors together,
A1F1, is likely to be the best description of the modelling of the Stern Review probably
BAU (Garnaut 2007). Key among the rea- underestimated significantly the risks of high
sons is the growth rates of the developing damages from BAU, perhaps by 50 percent
world, particularly China and India, and or more if one compares the first two rows of
their continued strong emphasis on coal Table 2. Much of the earlier literature grossly
(ECIEP 2006). underestimated the risks.
VOL. 98 NO. 2 richard t. ely lecture 23


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Figure 6. The Modelled Damages from Climate Change with Increasing Global Temperatures

Source: Dietz et al. 2007a.

Looking at both g and h, with the benefit the reasons that some earlier studies have lower
of hindsight, my inclination would be to place damage estimates than the Stern Review are
the base case from which sensitivity analy- twofold: they badly underestimate all four of the
sis is undertaken farther down the diagonal of elements just described, and in many cases their
Table 2—that is, with higher g and higher h. As approach to pure time discounting discrimi-
indicated in Section IIB, the “weight in the far nates, unjustifiably in my view, very strongly
future” from h 5 1 and d 5 0.1 percent sug- against future generations.
gests that there is a case for raising h, although
it remains true that many would see the implica- III.  Policy Instruments
tions of h 5 2 for intragenerational distribution
as very egalitarian. In a sense, moving down the At the heart of good policy will be a price
1h 2 g2 diagonal is taking on board the positions for GHGs—this is a classic and sound approach
of two commentators on the Review—Weitzman to externalities and is crucial for an incentive
(2007a, b) argued for greater emphasis on risk structure both to reduce GHG emissions and
and uncertainty, and Dasgupta (2007) for more to keep costs of abatement down. Indeed, in a
egalitarian values than those captured by h 5 1. world without any other imperfections, it would
In summary, one year on from the Stern be a sufficient instrument for optimal policy.
Review, with the benefit of new scientific evi- But it will not be enough in our world, given
dence and valuable economic discussions, my the risks, urgency, inertia in decision making,
views would have been modified as follows. First, difficulty of providing clear and credible future
the case has been strengthened that the bottom- price signals in an international framework,
up, disaggregated, less formal, risk-­evaluation market imperfections, unrepresented consum-
approach is preferable to aggregate modelling ers, and serious concerns about equity. A second
in investigating the case for action. The latter plank of policy will have to embrace technology
is particularly weak in relation to formal opti- and accelerate its development. Third, policy
mization. Second, within aggregate modelling, should take account of information and trans-
we have learned still more clearly that the key actions costs, particularly in relation to energy
issues are ethics and risks and that we have to efficiency. Fourth, it should provide an interna-
look at them together to form a serious view on tional framework to help with combating defor-
damages. Third, our own modelling probably estation, which is subject to a number of market
underestimated the risks from BAU. Fourth, failures. And fifth, policy should have a strong
24 AEA PAPERS AND PROCEEDINGS
international focus, to promote collaboration,
take account of equity, and reduce global costs.
Careful analytical investigation by econo-
mists of policies on climate change involves the
whole range of the tools of our trade, including
the economics of risk and uncertainty, innova-
tion and technology, development and growth,
international trade and investment, financial
markets, legal issues, ethics and welfare, as well
as public and environmental economics. It will
no doubt require the development of further
analytical methods. And it necessitates close
collaboration with scientists and other social
scientists.
Our focus here in this very brief discussion
of policy will be on price-oriented mechanisms
and on technology, but we should also note a
sixth key element that is often overlooked in dis-
cussions of economic policy, namely how pref-
erences change as a result of public discussion.
This was an integral part of John Stuart Mill’s
(Mill 1972 [1861], 262) perception of democracy
and policy formation (see also the discussion in
Chapter 9 of Stern, Jean-Jacques Dethier, and F.
Halsey Rogers 2005). In this context, it involves
a change in public understanding of responsi-
ble behavior. Thus, people will spend time on
separating out different elements of waste for
recycling, or they will drive more carefully, not
only because there may be a financial incen-
tive for recycling or penalties for bad driving,
but also because they have a view of responsible
behavior.
Pricing an externality can be done in a number
of ways. First, there is carbon taxation; second,
carbon trading on the basis of trade in rights
to emit which are allocated or auctioned; and
third, implicit pricing via regulations and stan-
dards which insist on constraints on actions or
technologies which involve extra cost but which
imply reductions in emissions. Each of the three
has different advantages and disadvantages and
all three are likely to be used. Understanding the
pros and cons, where the different mechanisms
can and should be used, and how to deal with
problems of overlaps, are all very important
issues. We have the space to look briefly only at
a few of the relevant considerations.
Taxes have the advantage of being imple-
mentable by individual governments without
international agreement. All taxes are conten-
tious but those on recognized “bads” such as
tobacco, alcohol, or carbon emissions may be
MAY 2008
less so than others and allow the balance of taxes
to adjust away from other taxes such as income
or VAT; alternative uses of revenue are possible
too, including those related to climate change.
We should beware, though, of arguments about
double dividends: environmental taxes have
dead-weight losses in addition to their benefi-
cial effects in addressing externalities. Taxes on
GHGs would require measurement of GHGs,
just as in trading, but taxes on petroleum prod-
ucts, coal, or other fossil fuels can act as fairly
good approximations, avoiding direct emission
measurement, which can be relatively costly to
small enterprises.
As discussed in Section IA, where the world
is perfect other than in relation to the tax in
question, quantity controls and price measure-
ments can have dual and essentially identi-
cal effects. Where there is risk, uncertainty,
and imperfections in this market and in other
parts of the economy, there will be price uncer-
tainty, quantity uncertainty, or both, depend-
ing on the policies chosen and the nature of the
uncertainty. Both price certainty and quantity
certainty are important: firms would like clear
and simple price signals for decision making;
quantity overshooting on emissions is danger-
ous. With learning and readjustment of pol-
icy (although not so frequently as to confuse
structures and issues), the difference in effects
between a tax-orientated policy and a quan-
tity/carbon-trading policy may not be so large.
Given where we start, however, in my view the
danger of overshooting emissions targets is of
great significance.
Tradable quotas, the second method of estab-
lishing a price for GHGs, have the advantage
of providing greater certainty about quantities
of emissions than taxes. The European Union
Emissions Trading Scheme (EUETS) has shown
that a big part of the economy can be covered
(currently around one half of European emis-
sions) with relatively low administrative bur-
dens by focusing on major emitting industries,
such as power.
By starting with allocations that are not paid
for and moving to auctions, trading can build
acceptance by industry because it allows for a
less dramatic adjustment. Free allocations based
on historical emissions do have important prob-
lems, however: they are likely to slow adjustment
since immediate profit pressures are lower; they
can give competitive advantages to incumbent
VOL. 98 NO. 2 richard t. ely lecture
firms that may succeed in getting large quota
allocations, thus reducing competition and pro-
moting rent-seeking; and they forego public
revenue. Thus, moving to auctioning over time
has strong advantages and should be a clear and
transparent policy.
An aspect of quotas and trading that is crucial
is their potential role in international efficiency
and collaboration. Developing countries (see
next section) have a strong and understandable
sense of injustice. They see rich countries hav-
ing first relied on fossil fuels for their develop-
ment, and thus being largely responsible for the
existing stocks of GHGs, then telling them to
find another, and possibly more costly, route to
development. They feel least responsible for the
position we are in, yet they will be hit earliest
and hardest.
International trading provides for lower costs,
from the usual arguments about international
trade, and provides an incentive for poor coun-
tries to participate. These arguments on cost and
collaboration are central to my view that there
should be a very substantial focus on carbon
trading in the policy of rich countries, with open-
ness to international trade, backed by strong rich
country targets for reductions, in order to main-
tain prices at levels that will give incentives both
for reduction at home and purchase abroad. Rich
and poor country targets will be discussed in the
next section.
Price volatility is sometimes said to be a prob-
lem with quotas and trading, and the EUETS is
cited as an example. But that scheme provided
some basic simple lessons that have been learned:
in its first stage (2005–2007), giving away too
many quotas collapsed the price. Quotas have
been allocated with greater rigor and stringency
in the second phase (2008–2012) and the price
for that phase is currently above €20 per ton,
already approaching the type of range indicated
as necessary. Volatility can be reduced by (a)
clarity, (b) firmness of quotas, and (c) broader
and deeper markets—greater trading across sec-
tors, periods, and countries. Particular measures
for dealing with volatility should be analyzed in
relation to, or after, these broader more market-
friendly approaches. And care should be taken
not to restrict international trade as a result; for
example, differences in caps on prices in differ-
ent regions might, because of attempts to arbi-
trage where prices are different but fixed, make
open trade difficult or impossible.
25
Further, difficulties arise in trading with coun-
tries that are not taking strong measures, price-
based or otherwise, against climate change.
There is, in principle, a case for levying appro-
priate border taxes on goods from countries
that do not otherwise embody a carbon price. A
system analogous to the operation of the border
procedures for VAT could be envisaged. My own
view is that this should be a last resort. There
are many searching for arguments on protection
that might climb on the bandwagon. The best
way forward is to build international collabora-
tion with a positive and constructive approach.
Regulation and standards can give greater cer-
tainty to industry. This can accelerate responses
and allow the exploitation of economies of
scale: lead-free petrol and catalytic converters
are probably good examples. Misguided regula-
tion, on the other hand, could reduce emissions
in very costly ways. Again urgency points to a
role for regulation/standards, and careful eco-
nomic analysis can keep costs down. In thinking
about these costs, however, we should remark
that there are a number of examples in the his-
tory of the motor industry where innovations on
safety or pollution were resisted by industry on
cost grounds, only for compliance costs to turn
out to be much lower than manufacturer pre-
dictions; for Environmental Protection Agency
(EPA) vehicle emission control programs,
industry stakeholders predicted price changes
to consumers that exceeded actual changes by
ratios ranging from 2:1 to 6:1 (John F. Anderson
and Todd Sherwood 2002).
While taxation, trading, and regulation will
all have roles to play, it is important to think
carefully about how they might interact. For
example, if taxation and carbon trading overlap,
there are likely to be problems in establishing a
clear and uniform price for carbon, leading to
confused signals and inefficiency. And strong
regulatory targets such as renewables percent-
ages could, without care, result in low demand
on carbon markets.
Our discussion of technology will be very
brief, but in my view, policy in this area will
be of great importance—we cannot simply leave
the correction of externalities to carbon mar-
kets or taxation. There is a standard argument
on knowledge and technology which sees ideas
and experience as having positive externalities.
Figure 7 shows that experience is indeed impor-
tant in the electricity industry—it seems that in a
26 AEA PAPERS AND PROCEEDINGS MAY 2008

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Figure 7. Cost of Electricity for Different Technologies

Note: The number in brackets indicates speed of learning: 65 percent means that unit costs are 65 percent of the previous
level after a doubling of production.
Source: Stern 2007, 254.

number of “less mature” technologies costs can seen a number of exciting and promising devel-
fall quite sharply with cumulative experience. opments, such as in ­materials and technologies,
Further, the rate of fall is different for different other than silicon, for photovoltaics.
technologies. This tells us that public support The international aspects of technology are
for deployment—such as feed-in tariffs, which crucial too. We all gain from reduced emissions
may be different for different technologies—has if others adopt cleaner technologies quickly.
a strong foundation. Care with applying such Thus, a balance of private return to innovation,
incentives is necessary to avoid the dangers of for example through patents, and rapid sharing
bureaucrats trying to pick private sector techno- must be found. This should be part of a global
logical “winners.” deal or framework to which we now turn.
Research and development (R&D) in basic
technologies also require public support. It is IV.  A Global Deal
remarkable how much public support for R&D in
energy has fallen since the early 1980s (see Fig­ Climate change is global in its origins and in
ure 8). Part of this was probably due to low energy its impacts. An effective response must there-
prices,27 but nevertheless the now-­recognized fore be organized globally and must involve
urgency of developing low carbon technologies international understanding and collaboration.
requires a strong reversal of this trend. Private Collaboration, if it is to be established and sus-
and public sector R&D on energy have moved tained, must be underpinned by a shared appre-
closely together and this is an area where public- ciation that the methods adopted are: effective
private partnership to enhance both private and (on the scale required); efficient (they keep costs
social returns, and to cover different risks, will down); and equitable (responsibilities and costs
be crucial. Fortunately, the last few years have are allocated in ways that take account of wealth,
ability, and historical responsibility). The incen-
27
tive structures must be such that solutions are
Extensive privatization has probably played a role as
well. For example, the UK’s nationalized National Coal incentive-compatible. And country-by-country
Board and Central Electricity Generation Board had R&D political support must be built, as this is what
departments of international distinction. will sustain policies over time.
VOL. 98 NO. 2 richard t. ely lecture 27













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Figure 8. Public Energy R&D Investments as a Share of GDP

Source: Stern 2007, 401.

Public support for action will be founded more a framework in which each country, or
not only on recognition of the magnitude of group of countries, can assess its own respon-
the problem, but also on the realization that it sibilities and targets with some knowledge of
is possible to construct collaborative policies where the rest of the world is going and how it
that are effective, efficient, and equitable. It is a can interact.
great responsibility of economists to help design On targets—a key element of effectiveness,
those policies. And they must do so urgently— or action on an appropriate scale—we should
the international discussion is moving quickly be clear how far the international discussion
and key decisions will be taken over the next has already moved. The G8–G5 summit chaired
few years. by Germany in Heiligendamm in June 2007
The following is my own attempt to describe declared a world target of 50 percent reductions
the outline of a possible global deal based on by 2050. As sometimes happens in international
the preceding analysis and on my own intensive communiqués, not all details (such as base date
experience over the last two years of involve- and levels of agreement among attendees) were
ment in public discussion, taking account of the clear; but it was a significant marker nonethe-
recent UNFCCC meetings at Bali last month. less. And it is broadly consistent with the type
Let us begin with overall reductions targets and of stabilization range, around 500ppm CO2e
the allocation of responsibilities across coun- for example, discussed in Section I. In what
tries. Our earlier discussion of trading, technol- follows, unless otherwise stated, emissions
ogies, and deforestation will then allow us to see reductions will be measured from 1990, cover-
quickly the broad structure of a global deal. Let ing all GHGs (in the six-gas Kyoto sense) and
us be clear at the outset that this should not be emissions sources. The Heiligendamm 50 per-
seen in the overly formal way of a WTO discus- cent target is for the world as whole and it is
sion, founded in legal structures, with compli- generally agreed (see below) that, in the spirit
ance driven by sanctions, and where no one is of the Kyoto language of “common but differ-
bound until the full deal is agreed. This is much entiated treatment,” the richer countries should
28 AEA PAPERS AND PROCEEDINGS
take ­ responsibility for reductions bigger than
the average. In what follows, we shall think of
rich country reductions as including those dis-
charged by purchases on international markets.
At Bali in December 2007, three coun-
tries, Costa Rica, New Zealand, and Norway,
declared targets of 100 percent reductions by
2050, i.e., “going carbon-neutral.” The latter
two are highly likely to need international pur-
chases to get there. Note, too, that reductions of
more than 100 percent are possible—many in
developing countries would regard targets for
rich countries above 100 percent as appropriate,
given past history—and that such reductions
that would almost inevitably involve interna-
tional purchase.
California has a target of 80 percent reduc-
tions by 2050. France has its “Facteur Quatre”:
dividing by 4, or 75 percent reductions, by 2050
(Stern 2007, 516). The United Kingdom has a
60 percent target but the Prime Minister Gordon
Brown indicated in November 2007 that this
could be raised to 80 percent (Brown 2007).
Australia, under the new government elected
at the end of November 2007, has now signed
Kyoto and has a target of 60 percent (Kevin
Rudd 2007); 80 percent is under considera-
tion after the Garnaut Review is published next
summer.
Targets for 2050 seem far away but the
long lifetime of many investments means that
early decisions are needed to reach them.
Intermediate targets are also being set. At the
European Spring Council, 20–30 percent targets
were set for 2020; Germany has set 40 percent
targets by 2020. The European Council also set
targets for renewables and CCS for 2020 and
beyond, but it is the overall emissions targets,
and their achievement, which are crucial. How
they are achieved country by country will vary
and must take account of economic as well as
environmental, social, and political consid-
erations. At Bali, many were pressing for rich
countries to accept 25–40 percent cuts by 2020.
That is indeed in the right range for rich country
cuts of 80 percent by 2050 and is now at least
an initial 2020 benchmark. Overall, in discus-
sions of global and rich country targets, ranges
consistent with the criteria of effectiveness and
equity are now the basic benchmarks, and many
key commitments have been made. Delivery
on targets at reasonable cost—essentially effi-
ciency—is, of course, crucial and a challenge.
MAY 2008
Policies that could support this constituted the
subject of Section III and should be at the heart
of a global deal.
Let us investigate equity in a little more detail.
The history of flows and their relation to future
stabilization targets should, in my view, be
central to a discussion of equity. All too often,
equity is seen solely or largely in terms of the
relative level of future flows (for example, per
capita convergence by 2050). A few numbers and
a little basic arithmetic will help to understand
the issues. Currently, global emission flows are
around 40–45 Gt CO2e. With a world popula-
tion of around 6 billion, that means average
global per capita emissions are around 7 tons.
Given that the world population in 2050 will be
around 9 billion, in order to achieve 50 percent
reductions (i.e., an aggregate flow of around 20
Gt CO2e) by then, per capita emissions will have
to be 2–2.5 tons. And since around 8 billion of
these people will be in currently poor countries,
those countries will have to be in that range28
even if emissions in currently rich countries
were to fall to zero. It is clear from this basic
arithmetic that any effective global deal must
have the currently poor countries at its center.
From the point of view of equity, the num-
bers are stark. The currently rich countries are
responsible for around 70 percent of the existing
stock, and are continuing to contribute substan-
tially more to stock increases than develop-
ing countries. The United States, Canada, and
Australia each emit over 20 tons of CO2e (i.e.,
from all GHGs) per capita, Europe and Japan
over 10 tons, China more than 5 tons, India
around 2 tons, and most of sub-Saharan Africa
much less than 1 ton. Recent per capita CO2
emissions (i.e., omitting other GHGs) for some
countries are illustrated in Figure 9.
In the lower part of this graph are three big,
fast-growing developing countries. China is
growing especially quickly. Even with fairly
conservative estimates, it is likely that, under
BAU, China will reach current European per
capita emissions levels within 20–25 years. With
its very large population, over this time China
under BAU will emit cumulatively more than
the USA and Europe combined over the last 100
28
In this context, I am referring to absolute emissions
originating in the country rather than who pays.
VOL. 98 NO. 2 richard t. ely lecture 29



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Figure 9. Per Capita CO2 Emissions 1in tons 2

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years. That is one indication of the urgency of CO2e as a reservoir sized 270ppm CO2e, which
finding a global response quickly. the world will get close to exhausting over the
But let us keep focused on equity. With 80 200 years between 1850 and 2050. If we start
percent reductions by 2050, Europe and Japan the clock in the late 1980s or now, it would be a
would be around the required two-ton global reservoir sized around 140ppm CO2e or 120ppm
average level. An 80 percent reduction by the CO2e, respectively.
United States, Australia, and Canada by 2050 From this perspective, equalizing the per cap-
would leave them around four tons, twice the ita flows of emissions—or the size of the glass
required average level. Thus, a 50 percent over- drawn per person per year from the reservoir—
all reduction and an 80 percent rich country by 2050, shortly before it is dry, is a very weak
reduction would still leave average rich country notion of equity. It takes no account of all the
flows above the world average in 2050. guzzling that took place by the better-off over
Turning to stocks, let us think about the path the preceding 50–200 years (depending on when
from some initial level to a stock stabilization (to we start the clock). There is a very big difference
be specific, suppose that level is 550ppm CO2e), between a stock and a flow notion of equity. An
and about who consumes what along the way. We 80 percent reduction of flows by rich countries
can think of the initial level as 280ppm CO2e, by 2050, in the context of a 50 percent reduction
corresponding to preindustrial times (around overall, is not a target for which rich countries
1850); or we could start 20 years ago (around should congratulate themselves warmly as dem-
390ppm CO2e), when the problems of climate onstrating a splendidly powerful commitment
change began to receive strong policy attention; to equity. And the contract-and-converge argu-
or we could start now (around 430ppm CO2e). ment for some common flow level, or for using
One perspective on equity would be to see the such a level as the eventual basis of trading, on
difference between 280ppm CO2e and 550ppm the asserted grounds that there are “equal rights
30 AEA PAPERS AND PROCEEDINGS
to emit or pollute,” does not seem to me to have
special claim on our attention.29 Rather, the tar-
get of equalizing by 2050 (allowing for trade)
may be seen as being a fairly pragmatic one, on
which it might be possible to get agreement, and
one that, while only weakly equitable, is a lot
less inequitable than some other possibilities,
such as less stringent targets for rich countries.
If we take any particular good, it will gener-
ally be true that rich people consume more than
poor people. That is simply an expression of
their being richer. In the case of the reservoir,
or the “contents of the atmosphere,” it is hard
to think of an argument as to why rich people
should have more of this shared resource than
poor people. They are not exchanging their labor
for somebody else’s and they are not consuming
the proceeds of their own land, or some natu-
ral resource that lies beneath it. I do not have
any special “correct” answer to the challenge of
understanding equity here, but it is a challenge
we cannot avoid discussing. Any global deal will
have to involve some implicit or explicit under-
standing over the sharing of this “reservoir.”
The key elements of the global deal have, with
one exception, now been raised and ­discussed.
Let me express the deal or framework in terms
of two groups of three headings, the first cover-
ing targets and trade and the second covering
programs for which public funding is likely to
be required. This set of six policies or programs
is the international part of a deal. The domestic
policies will vary across countries, using dif-
ferent combinations of policy instruments and
technologies as discussed in Section III. The six
elements of a global deal are expressed in bullet
point form in Tables 3 and 4.
The first element of the first group covers the
targets. The global target was explained and jus-
tified in Section I and the distribution of targets
above in this section. The second, the impor-
tance of emissions trading, was emphasized in
Section III: the justification for a major focus on
GHG trading in policy lies in its promotion of
both efficiency and collaboration. Unless financ-
ing flows for the extra costs of reducing emis-
sions are available to poor countries, they are
extremely unlikely to join the effort on the scale
29
Asserting equal rights to pollute or emit seems to me
to have a very shady ethical grounding. Emissions deeply
damage and sometimes kill others. Do we have a “right”
to do so?
MAY 2008
and pace required. They feel the inequities of
the situation and phenomena acutely. Just when,
they argue, they are beginning to overcome pov-
erty, in part by rapid growth, they should not be
asked to slow down. Financing, together with
technology demonstration and transfer, will
be needed to convince them that moving to a
low-carbon growth path is not the same thing as
moving to a low growth path.
The third element refers to the short- and
medium-term approaches to trading between
rich and poor countries. The current system, the
Clean Development Mechanism (CDM), was
established by Kyoto and operates at the level
of a project in a poor country (a so called non-
Annex 1 country in the Kyoto Protocol). If a firm
in a rich country (an Annex 1 country) is part of
a trading scheme (such as the EUETS) which
recognizes the CDM, then that firm can buy
an emissions reduction achieved by the project,
subject to the project using technologies or
approaches from an admissible list. The amount
of the notional reduction comes from compar-
ing the project with a counterfactual—what the
entity doing the project might otherwise have
done. Approval of a project goes through the
poor country authorities and a special institu-
tional structure, currently in Bonn. The system
is slow, cumbersome, and very “micro.”
Trading on the scale required to reach the
type of targets discussed (see Table 3) requires
a much simpler, “wholesale” system.30 At the
same time, to get agreement with poor coun-
tries, it will have to continue to be “one-sided,”
as in the CDM, i.e., you can gain from innova-
tion, but are not penalized for BAU. Wholesale
measures can include technological benchmarks
such as employing CCS (currently excluded
from CDM), or sectoral benchmarks such as
getting below a certain amount of CO2 per ton
of cement. As one-sided trading measures, the
benchmarks could be set ambitiously.
After these trading mechanisms have been in
place (with associated technology sharing) for
a while, developing countries will be able to
have confidence that a trading system can work
on an appropriate scale. Then it would be rea-
sonable to ask them to accept targets ­consistent
30
This scale is derived from preliminary calculations
using a trading model at the UK Department of Environ­
ment, Food, and Rural Affairs (DEFRA).
VOL. 98 NO. 2 richard t. ely lecture 31

Table 3—Key Elements of a Global Deal: Targets and Trade

• Confirm Heiligendamm 50 percent cuts in world emissions by 2050 with

rich country cuts at least 75 percent.
• Rich country reductions and trading schemes designed to be open to
trade with other countries, including developing countries.
• Supply side from developing countries simplifed to allow much bigger
markets for emissions reductions: “carbon flows” to rise to $50–$100
billion per annum by 2030. Role of sectoral or technological benchmar-
keting in “one-sided” trading to give reformed and much bigger CDM
market.

Table 4—Key Elements of a Global Deal: Funding Issues

• Strong initiatives, with public funding, on deforestation to prepare for

inclusion in trading. For $10–15 billion per annum could have a pro-
gramme which might halve deforestation. Importance of global action
and involvement of IFIs.
• Demonstration and sharing of technologies: e.g., $5 billion per annum
commitment to feed-in tariffs for CCS coal could lead to 301 new com-
mercial size plants in the next 7–8 years.
• Rich countries to deliver on Monterrey and Gleneagles commitments
on ODA in context of extra costs of development arising from climate
change: potential extra cost of development with climate change upward
of $80 billion per annum.

with overall global goals in the context of a
strong set of goals by rich countries. If we look
for targets from poor countries now, the only
ones that would be accepted would be far too
loose and would knock the bottom out of inter-
national trading, i.e., collapse the price. And in
the future these loose targets would be likely to
form a base-line for subsequent discussion. That
is why a staged approach is essential if currently
poor countries are to accept participation in
responsible global stabilization so that by 2050
their emissions average around 2 tons per capita.
Recall that this is a half or a third of China’s
current level. It is very unlikely to be possible
to find financial flows on the scale required to
incentivize appropriate action from the public
sector of rich countries. Witness the difficulty
in getting resources for Overseas Development
Assistance (ODA), which will be strained still
further by the challenge of adaptation (see
below). The trading system provides for private
flows.
The public funding requirements are grouped
in three elements in Table 4. Each would require
a paper in itself for appropriate treatment,
and we can give only headlines. Deforestation
accounts for up to 20 percent of current emis-
sions; the numbers are not easy to specify pre-
cisely—probably 5–8 Gt CO2e per annum. These
flows could be roughly halved, in my view, for
around $5 per ton of CO2, ­taking into account
opportunity costs of land and the institutional,
administrative, and enforcement measures nec-
essary. Some have estimated higher costs (e.g.,
McKinsey—Enkvist, Nauclér, and Rosander
2007) but there appear to be large amounts of
“initial” reductions available at lower costs, par-
ticularly if programs are large-scale and coordi-
nated across countries (for further discussion see
Myers 2007; Daniel Nepstad et al. 2007; Niels
Anger and Jayant Sathaye 2007). This would
help to avoid reduced deforestation in country
A simply displacing activity and thus increasing
deforestation in country B. Public sector flows
32 AEA PAPERS AND PROCEEDINGS
can be combined with private sector flows as
avoided deforestation is brought into the carbon
trading process so that all countries are given
incentives. Indeed, one of the responsibilities of
the publicly funded program would be to work
toward trading.
The second element in this second group, the
demonstration and sharing of technologies, is
urgent; financial resources must be made avail-
able and institutional arrangements designed.
This is an important area for economic research.
One problem of particular urgency, for reasons
described above, is the demonstration of CCS
for coal. There are no current plants using CCS
for coal-fired generation on a commercial scale.
From 2015 or 2020 on, the world will need most
of its new coal-fired electricity generation plants
to be operating with CCS if it is to have any
chance of realizing its targets. If CCS cannot
work on the necessary scale, then we need to
know soon and follow alternative strategies. At
present, however, it does look promising. There
is geological work to be done to identify storage
capacity, and careful legal and regulatory work
to be done to allocate risk and responsibility.
Geology and coal vary greatly across the world
and many demonstrations of commercial-scale
plants are necessary. Feed-in subsidies, world-
wide, of around $5 billion per annum could sup-
port 301 such plants over the next 7–8 years
and cover a broad range of examples.31
There should also be support for many other
technologies. We do not know what the most effi-
cient clean technologies will be in the future, and
the answers are likely to vary with location. CCS
is emphasized here simply because we can be
fairly confident that BAU will involve a great deal
of coal for electricity over the next 20–30 years.
Perhaps it will be a medium-term technology and
be replaced by others over the longer term.
Finally, in the global deal, I would emphasize
an element that has not been discussed here and
that will be of great importance. Even with very
responsible policies, the world is likely to see
an additional 1–2°C of warming over and above
the 0.8°C it has already experienced. Adaptation
will be necessary worldwide and will be par-
ticularly difficult for poor countries. Recently,
31
Own calculations using, for example, the McKinsey
cost curve, and working with power stations of a few hun-
dred megawatts. I am grateful to Dennis Anderson for his
advice.
MAY 2008
the United Nations Development Programme
(UNDP) estimated additional costs for develop-
ing countries of around $85 billion per annum
by 2015 (UNDP 2007, 15). And they will pre-
sumably rise after that.
Such extra financing will be hard to find. It
may be compared with the $150–200 billion per
annum extra that would arise if the Organisation
for Economic Co-operation and Development
(OECD) countries moved to 0.7 percent GDP in
ODA by 2015, as many of them have promised.
The ODA promises of the 2002 UN International
Conference on Financing for Development in
Monterrey, Mexico, in connection with the
Millennium Development Goals, and of the
2005 UK-chaired G8 Gleneagles summit on
Africa, and preceding EU commitments in
July, were powerfully argued and justified at the
time. They took little account of climate change.
If that aspect is added, as it should be given
the magnitude of the challenge, and combined
with the historical responsibilities for stocks of
GHGs and the implied consequences for poor
countries, then the argument for 0.7 percent, in
my view, becomes overwhelming. The Stern
Review left the argument at that point, although
a case could have been made for increasing the
ODA targets.
The framework I have now described does, in
my view, meet the criteria of: effectiveness—it
is on the right scale; efficiency—it relies heavily
on markets and market-orientated innovation;
and equity—it does at least give some specifi-
city to the “common but differentiated responsi-
bility” already accepted internationally. It builds
on existing commitments and some aspects of
the current discussions in international fora. It is
also designed to give some realistic opportunity
for the major developing countries to become
strongly involved, as they must if serious targets
are to be agreed and achieved.
It is a framework that could allow all coun-
tries to move quickly along what they see to be
a responsible path. What is very striking here
is how broadly basic understanding has already
been established. Country by country, we see
targets being erected and measures being set
by individual countries recognizing their own
responsibilities as they see international agree-
ment being built. People seem to understand
the arguments for action and collaboration on
climate change much more readily than they
do for international trade. But I do not want to
VOL. 98 NO. 2 richard t. ely lecture
p­ retend that the problems and necessary actions
are universally recognized and accepted. Scien­
tific agreement seems broad and deep, but we
cannot yet say that about economic policy, or
about economists. This is a time for exchange
of ideas and intensive discussion. Economic
policy is much too important here to be left to
noneconomists.
It is intensive public discussion that will, in
my view, be the ultimate enforcement mecha-
nism. For example, in November 2007 we saw an
Australian prime minister thrown out of office in
part because of his perceived weakness on this
issue. It is remarkable that when elections come
around, politicians recognize strong public inter-
est and demand for action. And it has become a
unifying and defining issue in the structures of
Europe. It has not moved at the same pace in all
countries, but we are also seeing strong changes
in perception in the key countries of the United
States, China, and India.
Beyond discussion, there are some promis-
ing movements in world and individual coun-
try policy. The UNFCCC 13th Conference of
the Parties, COP 13, in Bali in December 2007
was a major step forward, with all countries
involved broadly (but not universally) recogniz-
ing the need for overall 50 percent cuts by 2050
and 25–40 percent cuts by rich countries by
2020 (although only the phrase “deep cuts” was
agreed). There was progress on international
action on deforestation. But it was the launch of
negotiations only; it was not an agreement on a
shared global framework.
The discussion of that global framework will
move forward strongly over the next few years. It
is vital that economics and economists be more
strongly involved, particularly if the criteria of
efficiency and equity are to play their proper
role. It is the analytical application of these two
criteria to practical policy problems that is at
the heart of public economics. The challenge of
climate change is especially difficult because it
covers so much of the economy, is so long term,
is so full of risk and uncertainty, is so demand-
ing internationally, and is so urgent because of
the problem itself and the pace of public discus-
sion and decision making. It is also a long-term
problem for analysis. We will be learning all the
time and policy will be made and reformed over
coming decades.
It is dangerous, in my view, for us as econ-
omists to seem to advocate weak policy and
33
procrastination and delay under the banner of
“more research to do” or “let’s wait and see.”
The former argument is always true but we have
the urgent challenge of giving good advice now,
based on what we currently understand. And
the latter, in my view, is misguided—waiting
will take us into territory that we can now see is
probably very dangerous and from which it will
be very difficult to reverse. Acting now will give
us, at fairly modest cost, a cleaner world and
environment, even if, as seems very improbable,
the vast majority of climate scientists have got it
wrong. If we conclude that whatever the merits
of the argument, it is all too difficult to make
and implement policy, then we should at least
be clear about the great magnitude of the risks
of moving to concentrations of 650ppm CO2e or
more, which are the likely consequences of no,
weak, or delayed action.
It is hard to imagine a more important and
fascinating problem for research. It will involve
all our skills and more, and it will require col-
laboration across disciplines. This is a time and
a subject for economists to prove their worth.
Looking at the quality of this company here
in New Orleans, I am confident that they will
do so.
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