The core argument of this report, entitled, "Better Growth, Better Climate", is that by investing in and building "better growth" we can make great strides towards managing the immense risks of climate change, and thus build a "better climate". In other words, fostering strong and sustainable growth in living standards can and should come together with a fundamental reduction in climate risk. That progress relative to these two objectives can support each other so well is, in large measure, because over the next two decades we have a remarkable coincidence of two vital transitions in world history.
The first is in the structure of the world’s economy and society. This will embody: a rapidly shifting balance in the source of economic activity from developed to developing countries; great moves of population into cities; rapid growth of population; significant changes in the ways we generate and use energy; movement out of agriculture in to (mainly) services; and still further pressure on forests, land and water. The second is a decisive two decades for a transition to a low-carbon economy which will determine whether or not we can avoid the immense risks of climate change. The first transition will happen come what may. The second is a fundamental choice of our generation. The central argument of this report, and the key insight that has shaped the analysis, is that if we manage the first transition well, we will have made great strides towards success in the second. If the first goes badly, the second will be much more difficult. We are at a fork in the road.
We have been brought to this point by a remarkable period in the economic history of the world. The last three decades have seen two decades of strong growth, driven in large measure by the emerging market economies, followed by the greatest financial and economic crisis in almost a century in the rich countries. In these decades, the international division of economic activity has been transformed. In 1985, the rich countries with 1 billion out of a world population of then 5 billion, had around two-thirds of the world’s output (PPP, current international $), whereas now they have less than half. The shares of global carbon dioxide (CO2) emissions have followed a similar track. In 1985, rich countries accounted for more than half of annual global CO2 emissions, whereas now they emit around a third. Whilst poverty in all its dimensions remains deeply troubling across the world, this period has seen life expectancy rise steeply and hundreds of millions have been lifted out of poverty. Demand for resources has risen sharply. Technological change in information and communications, in materials, and in biotechnology has been extraordinary.
The financial and economic crises in rich countries have contributed to faltering world growth. China, the most powerful driver of growth in the last three decades, is recognising that its growth will slow. At the same time China’s policy-makers also recognise that the pattern and structure of their growth should change to become more sustainable. Developing and emerging countries continue to see economic growth and its role in overcoming poverty as central to their development ambitions. The last quarter of a century has also brought a deepening understanding of the challenges of climate change, with the Intergovernmental Panel on Climate Change (IPCC) founded in 1988, and the United Nations Framework Convention on Climate Change (UNFCCC) in 1992.
The great economic questions of the coming years will be whether the world can continue the story of growth and poverty reduction, manage the further structural transformations which are in train, and tackle the immense and growing potential risks of climate change. Thus the report is about the next fundamental transformation of the world economy which follows from and is shaped by the great transformations of the preceding quarter of a century. At the heart of this next transformation, and where we will make our key choices, are our cities, energy systems and land use.
The rapid changes of the last three decades were part of long-term trends of economic history, but the acceleration was remarkable. Change in the next few decades will no doubt be different and there will be many surprises. But we can be fairly confident of the following: cities will grow rapidly and older cities will require reform and renewal; energy systems will be created as many countries pass through stages of development when energy demand will grow strongly and richer countries will refurbish their systems; and many of the battles to save and enhance forests and ecosystems will be resolved in the face of strong pressures from growth of population and demand for materials, food and water. Our decisions, for better or worse, implicit or explicit, considered or haphazard, will shape our cities, energy systems and land use for decades or centuries.
These next few decades are critical for climate change because, as a result of rapid hydrocarbon powered growth and the destruction of forests, we have already reached atmospheric concentrations of 400 parts per million (ppm) of CO2 or around 450ppm of CO2 equivalent (taking account of other greenhouse gases). If the world stays substantially above those levels for a long time it will be difficult or impossible to have a reasonable (say 50-50) chance of holding global average surface temperature to 2°C above pre-industrial levels. This is the level above which, in the words of the UNFCCC, climate change becomes dangerous, partly because the risk of tipping points and destabilising feedbacks increases strongly. We currently appear to be on a course which could take the world to 4°C or more, temperatures not seen for tens of millions of years. The consequences in terms of catastrophic events, desertification, flooding, sea-level rise and so on could cause hundreds of millions of people, perhaps billions, to move, likely resulting in extended and severe conflict.
Delay is dangerous because the principal greenhouse gas, CO2, is so long-lived and concentrations are very difficult to reduce. Furthermore, much of the relevant infrastructure and capital is long-lasting and, in a period of rapidly growing energy demand, we risk "locking-in" high-carbon equipment and structures. That the "window for action" is closing has been emphasised strongly by a number of international institutions including the International Energy Agency (IEA) and the World Bank.
The coinciding of these two transitions is both a challenge and an opportunity. The report shows that putting the response to these two challenges together offers a real chance of success on both. And in so doing it demonstrates that we have an extraordinary opportunity for growth, poverty-reduction, and a much more attractive and sustainable way of consuming, producing and living. That opportunity comes not just from the coinciding of the two transformations, but also from the very rapid advances in technology that we have seen in recent decades. For example, the extraordinary advances in information and communications technology (ICT) have enormous potential for resource efficiency and fostering further innovation. Furthermore, experience with various policies, such as carbon pricing, has taught us many lessons. We understand better, from both successes and failures, how to manage the kind of change experienced over the last few decades. And we can be confident that the technical advances we have seen, and that are on the way, will generate great further opportunities.
Failure to foster growth and poverty reduction, and to manage structural change will prevent the coherent global action necessary to manage climate change. Failure to manage climate change will undermine and potentially reverse the development achievements and poverty reduction of the last few decades. If we fail on one, we fail on the other. Will we behave in a way to seize opportunities for growth, and growth that is sustainable? I hope that the report will help steer us towards a positive answer.
It is this overall understanding and definition of the challenges of the next two or three decades, based on the analyses and lessons of economics and economic history, particularly of the last two or three decades, that have shaped the guidance given by the Economics Advisory Panel (EAP), which has advised the Commission. The EAP has not written the report, but its distinguished and independent economists have provided counsel and guidance, and have brought an extraordinary range of insight, talent and perspectives to it. Furthermore, the range of experience in different kinds of economics within the EAP and its international make-up reflect the character and structure of the economic challenges. Many of its members have participated at a senior level in making or guiding economic policy. They understand the realities of practical politics. They have provided challenge, rigour and a constructive spirit in offering their advice. In what follows there are a number of references to their academic contributions. A bibliography of some of their relevant writings is provided as an appendix to the report.
I am very grateful, as chair of the EAP and co-chair of the Commission, for the guidance they have given. I must emphasise, however, that whilst I have consulted with them and been guided by them, the views expressed in this note are my own.
Why another report now? Please excuse me if I start from the Stern Review published in October 2006. Technical progress has moved much more strongly than was expected at that time. There is more experience with climate policies. The world has struggled with a great recession. Meanwhile, the science looks still more worrying. Emissions have continued to rise, still more strongly than expected at that time, and some effects are coming through more rapidly than anticipated. The politics on emissions looks more worrying; in many countries the political will to act is weak. This report goes beyond the Stern Review in its central focus on both structural change and on how growth and climate action can be mutually supportive.
There are also important changes in the subject of economics. Many are probing more deeply into the determinants of development and growth, with great emphasis on innovation, learning and institutions. The "Schumpeterian" story is rising still further in the attention of economists, for example through the work of Aghion (an EAP member). There have been important advances too in behavioural economics, particularly associated with the work of Kahneman (an EAP member), which guide us on how decisions are understood and made, and how responses to change take place.
There have also been many helpful reports over recent years. The IEA, through its World Energy Outlooks, has examined energy systems and how they might develop, with a strong focus on the detail of economic and energy structures around the world and the energy investments that are necessary to reduce emissions on the scale required. They are the major source of much data and analysis on investment in energy infrastructure. The World Bank 2012 report Turn Down the Heat: Why a 4°C Warmer World Must be Avoided provides a comprehensive review of climate impacts at such temperatures, which have not been seen on the planet for millions of years. Angel Gurria of the Organisation for Economic Co-operation and Development (OECD) has brought to centre stage the need for zero-emission energy in the second half of this century and established the OECD as a leading institution for research on the economics of climate change. And the International Monetary Fund (IMF) has produced valuable research on energy taxation and subsidies and associated externalities and market failures. While this report is different in its emphasis on rapid structural change across the world economy, particularly in cities, energy and land use, it builds on the valuable earlier work of these institutions. And it draws on a whole range of perspectives and research from economics and other disciplines.
With the challenges defined in this way, it is clear that both standard growth models and the usual shorter term macroeconomic models of output and unemployment simply do not carry the features and analytical foundations which allow a satisfactory analysis of the key questions for the report. Standard growth models, often focused on the longer run, have offered real insights into how savings and investment, population growth and technical progress can combine to generate growth. Shorter-term macroeconomic models have been of help in guiding the management of demand, unemployment and inflation. But neither of them is designed to inform the analysis of radical structural change.
The transformations that will shape the coming decades are already under way. We cannot defer or "push out" the necessary transformational investments and innovation to some vague medium or longer term, to be examined and decided later, an argument also emphasised strongly, for example, in the work of Edenhofer (an EAP member), the IEA and many others. The structural transformations under way and the actions necessary on climate change involve major investments. Such investments will drive the transformations. They will boost growth and bring other valuable returns, for example to air quality and energy security. But transformations and major new investments can involve dislocations. Moving early and strongly towards the world I am describing is not an easy win-win. But a central conclusion of the report is that credible and coherent action now has great potential and attractiveness for growth, poverty reduction, ways of living, and sustainability — surely much greater potential than something that attempts minimal change whilst sending mixed signals to investors and trying to stick with current patterns.
This report takes a major step in the direction of bringing together economic analyses and perspectives that fit the analytical tasks at hand. In so doing it charts an attractive and wise way forward. It is not a rigid plan, but a path of growth and discovery which promises a strong and sustainable future of continued development and poverty reduction. It is focussed exactly on identifying and analysing key areas which are core to the processes of transformation and decision-making, i.e. cities, energy systems and land use, and key drivers of change, i.e. resource efficiency, infrastructure and innovation.
The nature of the problem and the need for deep and broad approaches to growth, poverty reduction and structural transformations has motivated the analytical guidance given by the EAP. On growth and structural change, the guidance of the EAP and the work of the report team have been much influenced by the Schumpeterian perspectives on medium- to long-term technological transformations. Such transformations are precisely what are at issue here. As Freeman, Perez (an EAP member) and others have shown, periods of major technological transformation are usually accompanied by innovation, investment and growth over a few decades.
This Schumpeterian tradition is complemented by, and interwoven with, models of learning and endogenous growth in the tradition of Arrow, Aghion (an EAP member) and others (see Aghion et al. 2014). The report is also informed by the Kuznets and Chenery analyses of the relationship between growth and sectoral change which in recent times have been deepened and taken forward by Rodrik and Spence (both EAP members). These are complemented again by advances in economic geography (see work by Krugman, Venables and others) and analyses of cities, often building on the pioneering work of Jane Jacobs. In India, for example, Ahluwalia (an EAP member), has led applied work on growth of cities and necessary infrastructure investment. Fan Gang, Garnaut and Stern (EAP members) have examined how urbanisation and sectoral change are transforming the Chinese economy. Ndulu (also EAP member) has provided guidance on transformation in Africa.
Modern public economics is at the heart of the Commission’s work on policy. Much of this body of theory proceeds by analysing both market failures and government failures. It is firmly based in the tradition of Meade, Samuelson, Arrow, etc. (and earlier Dupuit, Wicksell, Marshall and Pigou).
Emissions of greenhouse gases (GHGs) represent a market failure as the emitter does not bear the costs of the damage and disruption from their activities. In the Stern Review, I suggested that emissions of GHGs may be the largest market failure the world has seen: all people are involved in the cause, all will experience the impacts, and those impacts are potentially immense. In this sense carbon pricing, which corrects for the externality and thus promotes the sound functioning of markets, is the most urgent policy to get in place today. It involves a relatively simple application of widely accepted tax principles and can be applied in a number of ways, including through an explicit tax or cap-and-trade scheme, or by adjusting existing fuel taxes to reflect their carbon content. Market failures extend beyond the fundamental one of GHG emissions, to more dynamic failures such as the public spillover of ideas in research and development (R&D), networks, capital markets and information, as well as co-benefits of ecosystems, efficiency, health and so on. At the same time, governments who must shape the environment for investment and innovation can over-reach themselves or be influenced by vested interests. The presence of these more dynamic market failures potentially amplifies the size and duration of the consequences of government failure, making the issue of accountability of institutions all the more important. The analytical challenge here is to bring out and examine the dynamics associated with these perspectives. We need to combine the economics of Pigou with that of Schumpeter. Strong carbon prices, and strong investment in and policies towards R&D and innovation are likely to be very powerful in driving the necessary change. A number of members of the EAP have been strongly involved in the literature on modern public economics and its dynamics (Aghion, Rodrik, Spence, Stern, for example).
Policies for flexibility help manage processes of resource allocation arising from evolving patterns of demand, the advance of technology and the emergence of new competitors. Examples of such policies include trade openness, supportive labour market policies (including income support where necessary), investment in skills and education, support for R&D and innovation, flexible housing markets, competition policy, and product market regulation. All these can help promote movement of resources and manage dislocation, particularly in its effects on poorer people.
Credibility of policy will be just as important as its nature. Institutional structures, such as development banks, mechanics of collaboration and transparent long-term policy bodies can play a key role. Modern approaches to institutional economics can be very helpful here (a number of EAP members have emphasised this perspective). More broadly, the advice of the EAP has also recognised the vital role of institutions (social, economic, governmental, international, financial, and so on) in influencing how transformations can occur, and indeed their timing, structure and success (see, for example, the work of Besley and Persson, Acemoglu and others, including EAP members Aghion, Rodrik, Persson, Spence). If market failures themselves arise from or reflect problems in property rights, transaction costs, information and trust, then, in addition to standard government interventions (subject to issues around government failure), one can also think about the way in which institutional structures have been, and can be, created within and between communities, to help overcome problems of both government and market failure, and facilitate creativity and change. The insights of Ronald Coase and Elinor Ostrom would be a key starting point.
The whole report is essentially about risk management, on an immense scale, in structural transformation, in growth and poverty reduction, and in climate change. The EAP has not suggested a formal or narrow approach here. The economic theorist’s work-horse of expected utility theory, whilst helpful for some simple frameworks of decision-making, is not well-structured for the scale of risks, international action and difficulties of perception involved here. What is necessary is a broader approach, in the sense of an understanding of change, uncertainties involved, and strategies for managing and reducing risk. Such perspectives and analyses point to an examination of policy options according to what they could deliver in terms of a range of outcomes with their many risks and dimensions. That is how wise decision-making can be informed and guided. It provides a way to look at and assess advantages and disadvantages, pros and cons, and costs and benefits, with their associated uncertainties. It is an approach which can be called structured consequentialism in the sense that it provides a structured framework for decisions in terms of careful evaluation and assessment of possible consequences. It is transparent. But it does not proceed by attempting to summarise the entire consequences for the world into one model for net benefits and one optimal policy or one number for expected utility. In this context this latter approach is cavalier and often lacking in transparency and honesty as to what is behind the "results".
Our climate will change given past and future emissions. Adaptation to these changes is an important example of risk management and flexibility. Robust infrastructure will be of great importance to adaptation and flexibility in general. This report has focused primarily on the fostering of a low-carbon economy, and as such adaptation has not been at centre stage. We should not, however, take that as a statement that it is unimportant. Far from it, given the changes on the way it will be crucial. And it is important to recognise that mitigation, adaptation and development are intimately interwoven, in agriculture, buildings, transport, and infrastructure, including across the whole economy. Examples are in the report.
This next two to three decades constitute a crucial period for poverty reduction and advance in well-being across the full range of economic and human dimensions. The EAP has generally been informed and guided by a broad view of development, as embodied in the work of Sen and others, and a number of EAP members have contributed strongly to the literature on the meaning and measurement of poverty, and the processes for poverty reduction. The EAP has been fortunate also to have with it leading economists of the key international institutions associated with growth and development: The World Bank (Basu), IMF (Parry) and OECD (Tamaki). Their experience of the practical, political, and conceptual issues involved, as well as the economics, has been of profound importance.
Human behaviour, in the form of understanding and perceptions, reactions, decisions and so on, particularly in the context of rapid change, may not be as simple or systematic as portrayed in standard economic models. It is important to ask how decisions to follow a radically different path, and in real time, could emerge or be fostered. Here the EAP has been able to draw on the insights of modern behavioural economics, as led, for example, by Kahneman. Social movements can be powerful agents for change. Leadership will be at a premium. And sometimes when leaders get together in the face of shared threats they may take a more long-term view of policy than when narrowly driven by local politics – as, for example, with the building of international cooperation after the Second World War, which fostered a strong period of growth and trade in many countries. But such an outcome cannot be taken for granted. Much worse is possible. The better outcome depends on a shared understanding of dangers and of what can be done in the way of action. It is crucial to be able to see a constructive and attractive way forward. I hope that the report contributes to such an understanding.
Cooperation and simultaneous action is critical to success in the challenge of fostering growth and transformation and managing climate change. Greenhouse gas molecules in the atmosphere have the same effect regardless of origin. This is a collective action problem. Hence the international make-up of the EAP, and the concern to understand how individuals and nations can cooperate and learn together, have been key aspects of its work. For international cooperation, institutions matter, particularly in the context of anticipating the actions and reactions of others and building mutual confidence and, where possible, trust. Principles of game theory and the ideas of cooperation of Ostrom (see above) can provide valuable insight here.
The EAP took into account the challenges involved in the work leading to the crucial UNFCCC meeting in Paris at the end of 2015. These international discussions, ethically, economically and politically, should examine directly the critical question of equity. Climate change is deeply inequitable in both its origins and impacts. The analyses and recommendations of the report take collaboration and equity carefully into account.
Political economy inevitably pervades the whole report. Local, national and international policy structures and decisions are subject to many pressures by those who see themselves as potential winners or losers, particularly the latter. There are inevitably discussions and judgements at many places in the analysis about the nature of these forces and how they might play out. Most of the EAP members have worked in "real policy environments" and are keenly aware of the importance of these issues.
The work of the Commission has thus embodied or been informed by the fundamental economics of growth, structural transformation, economic history, economics of public policy, economics of risk, theories and experience of development and poverty reduction, international economics, and institutional and behavioural economics amongst others. These ideas, theories and perspectives are at the core of our approach. The subject matter requires breadth and depth in theory, evidence and perspectives.
It should be clear from the definition of the problem, and the theories and perspectives brought to bear, that it makes little sense to try to embed the analysis into one single model. The story is neither short-run management nor long-run growth around which much modelling is oriented. It is a story of transformation, disruption and radical change – stable structures are not what it is about. But that does not mean less theory, rather it means more, as I have argued. Many perspectives are involved and single rigid frameworks are not up to the task.
It is unfortunate therefore that the economic models in the climate literature have been heavily focussed, too heavily in my view, on one particular approach. These models are usually called Integrated Assessment Models (or IAMs) which have the worthy aim of bringing together scientific models of climate change and models of economic growth. These have made a worthwhile, although modest, contribution. Nevertheless the current literature, in its portrayal of potential damages, misses out much of the scientific risk, potential catastrophes and tipping points. There is little there, for example, of any seriousness about the potential for huge loss of life that could come with 4°C and above, both directly, and from the movement of people and resulting conflict.
In the analyses of the costs of action, such models usually embody a rigid economic framework of exogenous growth and fixed cost and production structures, thereby assuming away most of the challenges of investment, innovation and structural change which lie at the heart of the problem. In addition, they usually have rising marginal costs of action in a context where dynamic increasing returns may be important. Taken together, these defects in modelling have often led to damage from climate change being systematically and grossly underestimated and the costs of economic change being substantially overestimated.
These IAMs, which take the underlying structure of the economy over the coming decades as given, are simply not equipped to take on the analytical challenges of transformations identified here as being at the core of the issues. As Edenhofer has argued, it is time for a new generation of IAMs (see also Stern 2013 and Dietz and Stern, forthcoming, on the structures of the IAMs). There has indeed been some improvement. But even improved IAMs are likely to be very limited in their ability to capture the key elements of the kinds of perspectives and analyses, described above, which must be brought to bear. Yet it is these IAMs that have dominated much of the formal modelling of the economics of climate change, including estimates of the Social Cost of Carbon (SCC). And for the reasons described, the SCC is systematically, and probably substantially, underestimated in such models. To look across current literature on IAM models and to see where it stands on assessing potential damages from climate change and costs of action is essentially to "average" across work which is systematically biased.
Some models of economic growth have been used by Treasuries and some international institutions to assess the shorter-run impact of climate action on growth, e.g. Computable General Equilibrium (CGE) models (these are sometimes embedded in IAMs). These models often start from the assumption of an economy where resources are already efficiently allocated and there are no market failures. Therefore there is a danger that such model structures assume directly that introducing climate policy inevitably diverts resources away from profitable activities and thus has an impact on short-run gross domestic product (GDP). But we live in an imperfect, inefficient and constantly changing world where there are multiple frictions, unemployment and other dynamics, and multiple unpriced benefits from climate policies such as reduced local air pollution, increased energy security and stronger biodiversity. Thus, the models often fail to capture these key features when simulating the GDP impact of climate policy on output. We must recognise that there are some promising attempts (including from the OECD) to improve these models and some progress has been made. I would encourage further investment in such improvements.
No single model, however, is ever likely to be able to tell the full story of the dynamics of an economy with many sectors, many goods, where lives may be lost on a substantial scale, where innovation is at the core of the story and where there are complex imperfections. Multiple scenarios from multiple models will be valuable, including, multi-model comparison such as that undertaken by the Energy Modeling Forum (EMF), the Mercator Research Institute on Global Commons and Climate Change (MCC) and the Potsdam Institute for Climate Impact Research (PIK) for the Commission. Such an approach avoids the risks of cherry-picking from different model results. But the fundamental limitations of the models remain. In multi-model comparisons it is vital to examine the literature carefully for the systematic biases identified above: that should be a key aspect of any overall assessment in such exercises.
Notwithstanding the limitations of models, most model-based estimates of the long-run costs of efficient climate policy (see IPCC, AR5, WGIII) are in the order of 1-4% of global GDP in 2030 from taking ambitious climate action consistent with a 50-50 chance of stabilising global average warming at 2°C above pre-industrial levels. These costs will vary by country. But, and this is a crucial point, if policies are weak, misguided or inconsistent, action could be much more expensive; policy mistakes in the process of fostering the transition can be very costly. Much of the work of the Commission has been on how to do policy well. This is a point that extends far beyond these models.
It would be wrong to argue that managing the structural transformations will inevitably provide all the emissions reductions necessary for a responsible management of climate. The required urgency and scale of emissions reductions will necessitate going beyond a sound structural transformation, i.e. viewed as sound in the absence of concern over emissions. We do not want to pretend that emissions reductions are all win-win, or there is a "lunch" that is totally free. But the extra resources necessary for responsible management of climate provide a "lunch well worth paying for", particularly when we include, as we should, the co-benefits of a cleaner, safer, more energy secure, and more bio-diverse economy along with the huge benefits of reduced climate risk.
The approach of the report does not allow the precision, spurious in our view, which can come via the answer to certain questions through one single model. On the other hand by looking at a number of models, disaggregating, and bringing different perspectives, theory and ideas to bear, it does allow us to tackle the questions that matter. And it offers a perspective for an informed choice of strategy based on an assessment of the coming structural changes, the potential gains from managing them well, the close connections with GHG reductions, the co-benefits of those reductions, and the reduced risks of climate change. This is what broad perspectives and a marshalling of the lessons of economics and economic history as a whole can bring.
I trust that the perspectives and theories the EAP has brought to bear have both guided the work of the Commission and are essential for an understanding of the processes of growth and change, which are at the heart of the challenges and choices at the fork in the road where we now stand. I am deeply grateful to the members of the EAP for their work and guidance.
The project was advised by a panel of distinguished economists, leaders in their respective disciplines. While the Economic Advisory Panel (EAP) has provided valuable guidance that has influenced the work of the Commission, they were not asked to formally endorse the report and should not be taken as having done so. Their wide-ranging contributions are described in "Theories and perspectives on growth and change: Guidance from the Economic Advisory Panel to the report of the Commission" prepared by Nicholas Stern, Chair of the EAP.