Adams, Philip; Dixon, Peter --- "Climate change insurance" [2007] MonashBusRw 31; (2007) 3(2) Monash Business Review 6

Climate change insurance

Philip Adams, Peter Dixon

Greenhouse gas emissions can be cut at a moderate cost to the nation, say Philip Adams and Peter Dixon.

Recently, a petition was circulated among senior academic economists seeking endorsement for a statement on climate change. Key points were that warming of the world’s climate through human activity is undeniable; that preventive policies, such as carbon taxes, are urgently needed; and that developed countries such as Australia should demonstrate leadership by being involved in international efforts to cut emissions. We signed the petition for the following connected reasons.

First, compelling advice from the scientific community, including CSIRO, suggests that a sharp cut in world greenhouse gas (GHG) emissions would substantially reduce the risk of catastrophic climate change over the next century.

Second, as part of a worldwide effort, Australia could achieve deep cuts in its own GHG emissions at only a moderate cost in terms of reduced economic welfare. It is on this second point that economists have particular expertise, justifying the presentation of an economists’ petition.

Cutting GHG emissions is like buying an insurance policy: we incur a cost (a loss in GDP) to reduce a risk (catastrophic climate change). In any insurance decision, the cost matters. If a worthwhile reduction in risk costs 50 per cent of income, then living with the risk may be preferable. But if it costs 1 per cent of income, then taking the insurance policy may be the best option. So what will it cost?

For the last 20 years, we have undertaken economic modelling exercises for Australian and overseas organisations on the costs of GHG reductions. Our modelling and that of other quantitative economists around the world supports the claim in the petition that:

“Credible estimates suggest that a 50 per cent emissions reduction is achievable for less than one year’s economic growth.”

Exactly what this means can be explained in terms of the report by the Allen Consulting Group to the Business Roundtable on Climate Change (March, 2006). Modelling we contributed to that report shows Australia’s real GDP growing between now and 2050 at an annual rate of 2.2 per cent under the assumption of no new GHG policies. In this scenario, Australia’s GHG emissions by 2050 are 80 per cent above their level in 2000.

In an alternative scenario, Australia introduces an Emissions Trading Scheme (ETS) to reduce its GHG emissions by 2050 to 60 per cent below their level in 2000. Even with this very deep cut in emissions, Australia’s GDP grows between now and 2050 at an annual rate of 2.1 per cent. The implication is that a massive 60 per cent cut in GHG emissions (relative to the 2000 level) costs about 20 months growth – the level of GDP that we would have reached on 1 January, 2050 is not reached until 1 September, 2051. A lesser cut would incur a lower cost. Taking account of non-linearities (the first 1 per cent cut is much easier than the last 1 per cent cut), a reasonable estimate for the cost of the 50 per cent cut mentioned in the petition is 12 months growth.

This suggests that the national macroeconomic impacts of an ETS are moderate, but does this carry through at an industry level? The modelling cited above showed that potentially some industries will be adversely affected, but that those adverse affects could be mitigated by targeted allocation of permit revenue. There are two main alternatives for permit allocation: auctioning with the permit revenue retained by the government, or grandfathering in which the permits are given to emitters free of charge. In the scheme modeled for the Business Roundtable, a hybrid system was designed to lessen effects on areas of the economy likely to be most adversely affected by the scheme. Some permits were freely allocated to those affected owners of generators to ameliorate the impacts on their rate of return, while the remaining permits were auctioned. The auction revenue was then used, first, to compensate trade-exposed, energy-intensive industries such as metal manufacturers. The purpose here was to offset the impact of the ETS on energy costs and thereby neutralise the effects of the ETS on each industry’s international competitiveness. The remaining auction revenue was used to fund assistance measures for households, regions or small businesses deemed to have been ‘unfairly’ affected by the scheme.

Why do modelling results suggest that GHG emissions could be sharply reduced at seemingly moderate cost in terms of lost real GDP for the nation? Are these results plausible?

The main GHG-emitting activities are fossil-fuel-based provision of electricity and motor fuels. In Australia, these account for about 5.4 per cent of GDP. Advice from scientists and engineers indicates that the adoption of current alternatives to fossil-fuel-based technologies would no more than double the costs of electricity and motor fuels. As a back-of-the envelope calculation, this suggests that Australia could make a 50 per cent switch to alternative technologies at a cost of 2.7 per cent of GDP, a little over an average year’s growth. But this is a pessimistic view of the costs of climate insurance. If the world embraced the need for deep cuts in GHG emissions, we would expect rapid technical progress in GHG-benign technologies which would reduce the costs of their adoption.

Cite this article as

Adams, Philip; Dixon, Peter. 'Climate change insurance'. Monash Business Review. 2007.; Monash University ePress: Victoria, Australia. http://www.epress.monash.edu.au/. : 6–8. DOI:10.2104/mbr07031

About the authors

Philip Adams

Professor Philip Adams is Director of the Centre of Policy Studies, Monash University.

Peter Dixon

Professor Peter Dixon is the former Director of the Centre of Policy Studies, Monash University.