Is the economic impact of climate change really that small?

Climate change is coming and it will increasingly impact all our lives in one form or another. The question is not if, but by how much. Unfortunately, modelling the climate is hard and it took us decades to build models that are highly accurate and can exclude natural causes of climate change with a high degree of certainty. Unfortunately, much less work has been done on the economic impact of climate change.

Climate change can impact our daily lives through different channels:

  • Most directly, rising sea levels will lead to flooding of land close to the sea and destroy houses built there.

  • Higher average temperatures will impact the growth of grains and other food items, and not for the better. Especially rice is at a high risk of crop failure if temperatures rise just a little bit. Unfortunately, rice is also the main food source for most of the people on earth, so that crop failures would have a devastating impact on the local economies.

  • As everyone who experienced the recent heat wave in North America and Europe can attest, higher temperatures lead to lower productivity at work. Indoors, this can be compensated by air conditioning offices and retail spaces, but people who have to work outdoors face the full force of this effect. As a result, important industries like the construction industry face declining productivity and output.

  • Higher temperatures lead to adverse health effects ranging from the spread of diseases like Malaria to regions previously unaffected by them to an increased number of cardiovascular diseases. Especially people who are obese drop like the flies in hot weather.

  • Tourism is also affected by climate change, with hotter regions (e.g. in South East Asia or Latin America) losing income from tourism while cooler areas (e.g. Scandinavia or Canada) can expect to benefit from higher tourism income.

  • Energy consumption changes as well. If the world gets hotter, more energy will be needed to cool buildings in summer and heat them during extreme cold snaps in winter (note that climate change does not imply that temperatures are getting warmer in winter; instead it implies that we will face more extreme weather events). I live in the UK, where only 3% of homes are air conditioned and, man, how I would have loved to be in one of these airconditioned homes during the heat wave. The problem is if energy demand rises, energy prices are likely to increase as well, which in turn has an impact on overall economic growth.

The size and regional disparity of each of these effects is hard to estimate, yet, Roberto Roson and Martina Sartori have done exactly that. On average, they find that poorer countries face a bigger decline in GDP than richer countries. Ironically, while most developed countries are amongst the main emitters of CO2, they are also the ones that will face the smallest negative impact from climate change. This is due to the fact that most developed countries are located in temperate climates in the Northern Hemisphere and have enough money to invest in climate change adaptation and mitigation technologies. According to Roson and Sartori, countries like Canada, Switzerland or the UK could even see their GDP per capita increase the more the climate changes. Countries in Africa, central America and South and South East Asia, on the other hand face the biggest loss in GDP.

More recently, Matthew Kahn and his colleagues from the Dornsife Institute for New Economic Thinking published a paper that thoroughly analysed the likely impact of climate change on GDP growth in 174 countries in 2030, 2050 and 2100. Their results show a somewhat larger impact of climate change on growth and are reproduced in the chart below for some key countries and regions.

However, looking at the chart below, I cannot help but wonder if these predictions are realistic. The estimated impact on GDP per capita is generally close to zero for developed countries until the year 2050 and expected to reach 4% to 10% of GDP/capita by the year 2100. But note that this is the cumulative loss in GDP/capita, not the annual average loss. And I am sorry, but losing 10% of GDP over 80 years sounds like nothing.

And this is where the shortcomings of current models of the impact of climate change come into play:

  • All models that I have seen so far ignore second-round effects. As the Earth’s climate heats up, we will face more weather disasters like hurricanes, which can create tremendous economic damage. A strong hurricane hitting Miami or the US Midatlantic region will quickly lead to damages of several hundred billion Dollars. Similarly, droughts and flooding in Central America, the Middle East and Africa will likely lead to higher migration of poor people to developed countries in the North. The immigration crises we experienced over the last couple of years are likely only the beginning of a much larger displacement of people.

  • The papers I have read do not show estimation uncertainty around their projected numbers. It is one of my pet peeves that scientists who model climate change or any other scientific phenomenon put error bars around their projections to show the range of possible outcomes. Economists never do that – probably because they would have to admit that the estimation uncertainty is so large that everyone would realize how useless their predictions are. Just think of all the great economic forecasts in 2006 or 2007 that showed that a recession is unlikely and the projected decline in economic output from a housing crisis should be in the range of a few percentage points. Back then, it was the second-round effects that created the real damage on the economy and the global financial system. It was how banks and investors reacted, once they started to panic that caused the real damage to the economy. Econometric models are inherently smooth and thus almost never predict a significant crisis. How accurate are these predictions going to be when faced with an unprecedented phenomenon like climate change that has the potential to create widespread panic amongst investors and businesses?

  • Finally, we are already witnessing a “third round effect”, namely the political polarization in developed countries and the rise of anti-immigration parties. If the small number of migrants of the last couple of years can create the political upheaval we have witnessed since 2015, what kind of a political landscape will we face if there is a proper flood of migrants coming to the developed countries in the North? And what kind of economic policies will the politicians who get elected in such an environment, enact?

In short, I think the studies discussed here are a good start, but just like with climate science, we will need decades more research before we can model the economic impact of climate change accurately enough to use this data for investment purposes. Until then, investors will simply have to adapt to a changing economic environment as they go along.

Economic impact of climate change

Source: Kahn et al. (2019).