Nobel laureate Bill Nordhaus’ ideas for India

Oct 15, 2018 — Blog Post — 9 min read

William Nordhaus has won a share of the 2018 Nobel Prize in Economics for his contribution to climate economics. In this post from Ideas for India, Dean Spears discusses Nordhaus’ work and its implications for India. He contends that India is even more climate-vulnerable than realised by the Nobel laureate’s quantitative model that describes the interplay between the economy and climate.

Climate change may be the greatest externality that human economies have ever suffered. When I take an Uber from CR Park to the Indian Statistical Institute in Delhi, the exhaust fills the air we all share. When the coal plant in Kanpur generates energy to electrify villages in the state of Uttar Pradesh, the smoke diffuses for miles. Power plants and airplane flights in the US decades ago are already warming the atmosphere into which Indian children are born today. And all of us who are rich enough to be reading a blog are participating in emissions that will change lives for future generations.

That sounds like a daunting problem for economists. But, in fact, the solution is simple enough to be included in every introductory microeconomics class. The optimal response to an externality is to internalise it: make sure decision-makers have to pay the social marginal cost. The result is blackboard magic: families and businesses and everyone else would then choose the amount where the extra harm from the pollution just balances the extra benefits from the polluting activity. In other words, a carbon tax harnesses economic incentives to get climate policy right. And, with coloured chalk, it makes a beautiful blackboard diagram, too.

Drawing that picture is easy. Figuring out what number the carbon tax should be is a harder problem. For solving that problem, William Nordhaus won a share of the 2018 Nobel Prize in Economics. In the 1990s, Nordhaus built one of the first computer programmes that could do it. This is a Nobel-worthy contribution, and not merely because of its importance for practical policymaking. The Obama administration and other governments used Nordhaus’ model, among others, for quantitative regulation.

It is also worthy because of what it highlights for policy. Climate change – for all of its apparent enormity – is a problem within the reach of everyday economics. After Nobel prizes for frontier econometrics, for behavioural innovations, and for abstract theory, Nordhaus’ Nobel celebrates the classic lessons at the core of public economics – and the importance of translating these lessons into practice.

A radical proposal: Marginal cost should equal marginal benefits

Nordhaus developed an ‘Integrated Assessment Model’, often abbreviated as an IAM (Pindyck 2013). The model is ‘integrated’ because it combines a standard model of economic growth with a module that represents the climate science of the cumulative effect of emissions on temperature change. Then, the model wraps temperature change back to its economic consequences. An equation called the ‘damage function’ translates temperature increases into lost consumption.

Then, the model optimises. It chooses a carbon tax such that the benefits of polluting economic activity balance against the costs of climate damages. Those benefits are important: the optimal amount of carbon emissions anywhere in the world in 2018 is not yet zero, because emission-generating economic activity has important benefits. But, alternatives to carbon-based energy are becoming ever cheaper, and the world is becoming richer. As Nordhaus’ model concludes, the world should be moving towards drawing down emissions, even at an economic cost.

What makes the modelling so difficult is that the people involved are many and are diverse. Choosing an optimal carbon tax would have implications for urbanites and villagers in India today; for Bangladeshi children born into dangerous heat a few decades from now; for rich Americans upgrading their car; and for everyone, everywhere a century from now. Some are helped, many are harmed, and the billions upon billions of future victims add up to a lot of ‘marginal social cost’.

Nordhaus’ model, like any optimising IAM, has to balance these diverse costs and benefits for rich and poor people: today, tomorrow, and in the further future. This is done, like any other optimisation problem, with an objective function: a ‘social welfare function’ that adds up costs and benefits (Nordhaus 2014). Researchers building upon Nordhaus have shown that how the social welfare function values future benefits and costs relative to present ones matters. So does how it weighs harms to poorer people against harms to richer people. Still, a consensus has emerged that for a vast range of plausible social objectives, climate policy should be aggressive now and even more aggressive soon. If not, many future people will suffer climate damages.

Nordhaus’ original model, called DICE (Dynamic Integrated model of Climate and the Economy), rolled the whole world into one representative economy. IAMs have been criticised for being simple, but simplification is necessary for a model covering 300 years, complex processes, and the whole world’s economic growth (all optimised using 1990s computers). Nordhaus later developed DICE into RICE (Regional Integrated model of Climate and the Economy), a regionally-disaggregated version. India was one of RICE’s regions.

India is even more climate-vulnerable than IAMs realise

In developing a regional IAM, Nordhaus had to incorporate properties of each region. He drew these from empirical literature where available, and also had to make some quantitative assumptions. Over the years, as research has progressed, successive versions of the model have refined its assumptions. Empirical research on climate vulnerability is still ongoing. In fact, only in the past few years have applied micro-econometricians started to turn their identification strategies towards understanding the many effects of rising temperature (Greenstone and Jack 2015, Dell et al. 2014). When Nordhaus started, such estimates were not yet available. Among the lessons of the new econometrics of temperature is that climate damages may be even greater than Nordhaus’ model assumes. If so, decarbonisation would be an even more urgent priority.

India is particularly vulnerable to climate damages. In the international politics of climate change, small island nations are often cited as the big victims of rising temperatures. But India turns out to have a critical challenge of its own: the combination of heat and humidity (Im et al. 2017).

Because our internal chemistry generates heat, the human body needs to cool itself to survive (Sherwood and Huber 2010). When the air temperature is warmer than our skin temperature, the only way our bodies can cool themselves is by sweating: the evaporation of sweat takes away heat. In research on demographic data from 53 developing countries, Mike Geruso and I have recently documented a special effect of heat and humidity on early-life mortality (Geruso and Spears 2018).

The youngest babies are not yet able to regulate their body temperatures: they have been free-riding on their mother’s temperature regulation in the womb, and only develop the ability to control their sweat over the first few weeks of life. As a result, being born into a very hot and humid month is a large, previously under-appreciated threat to neonatal survival. Unsurprisingly, the risks of heat and humidity do not stop at birth. Melissa LoPalo, a Ph.D. student at the University of Texas at Austin, has recently used data on the productivity of survey interviewers to show that hot and humid days reduce the labour productivity of people who work outside.

For India, these facts are especially threatening. Some of the hottest days in the world are in sub-Saharan Africa. But when it gets hot in dry climates, human bodies can cool themselves with sweat. The Indian monsoon (and similar phenomena in South- and Southeast Asia) is what generates stretches of days that are both very hot and very humid. Globally, days that are very hot and humid are rare: many of the few such days that happen occur in Uttar Pradesh and Bihar. India, and especially the northern plains, are expected to have even more deadly hot and humid days under climate change. So, disadvantaged regions will become even more disadvantaged.

For now, the interaction of heat and humidity is not part of Nordhaus’ IAMs. Instead, damage functions reflect ordinary temperature. But there is no conceptual reason that an IAM could not incorporate humidity. Work towards that goal is underway. The upshot will be that India’s climate damages will be even more severe. In the model, the social marginal cost of emissions will increase, and mitigation policy will become an even greater priority.

What if the world does not cooperate?

Nordhaus’ models – both DICE and the regional RICE variant – are designed to solve for a single, global pattern of optimal carbon taxes. There was a time when policymakers might have hoped that the world would come together for just such a collaborative, ideal solution. But, these days, international climate cooperation feels politically remote.

Since 2015, the Paris Agreement has recognised the bottom-up nature of climate policy, rooted in domestic politics. Many observers now worry that the Paris pledges are insufficiently ambitious, inadequately implemented, or both. India could not stop climate change even by fully eliminating its emissions, and yet is highly vulnerable to changing temperature. For India, which must formulate its best response to the climate injustice of the developed world, understanding what to do in a deeply sub-optimal world is critical.

In their original form, DICE and RICE do not speak to bottom-up climate policy. But one power of IAMs is that they offer a common framework. Researchers can change it. Current research – such as by Princeton’s Climate Futures Initiative and others – is investigating what sort of equilibrium might emerge from bottom-up climate policy. One particularly important modification to IAMs is to incorporate co-benefits: benefits to today’s populations from reducing emissions. In India, one important co-benefit of reducing coal-burning would be reducing air pollution, by limiting the emissions of compounds that turn into hazardous particle pollution. Adding co-benefits to the balancing of costs and benefits in IAMs may bring optimal policy closer to the decision that the world would ideally make if it acted together.

A recurring theme of this research is that India is a region with much to gain from global climate mitigation policy, on the one hand, and from domestically cleaning up its own air, on the other hand. In Nordhaus’ presidential address to the American Economic Association, he quantitatively implemented an idea that had been proposed in the climate policy literature by others, including Scott Barrett. Nordhaus investigated using international trade policy to reward and punish ‘clubs’ of countries who do their fair share of emissions reductions. Trade policy could be used as a sanction to persuade countries to comply with international climate policy norms. In Nordhaus’ simulation, India consistently came out as one of the countries with the most to gain from climate cooperation. The implication is clear: India has a lot at stake in global climate policy, and in the politics of a best response to climate injustice.

You can use Nordhaus’ toolbox

Nordhaus’ particular IAMs are far from the last word on climate policy. They are valuable because they are a toolbox that anyone can download, modify, and use to investigate their own version of Nordhaus’ questions.

A few years ago, I collaborated with a research team that noticed something odd about the assumptions in Nordhaus’ model. RICE assumed that ‘total factor productivity’ (known to macroeconomists as the mysterious ultimate driver of economic growth) would rapidly increase and converge towards the rich countries, even in the world’s poorest economies. RICE also was using population projections that missed the fact that sub-Saharan Africa’s demographic transition is going slower than demographers once expected.

Anyone would hope that socioeconomic development in Africa, India, and the rest of the developing world happens quickly – but what if it does not? Then the future developing world would be poorer than Nordhaus was assuming, and climate damages would be impacting an already-more-disadvantaged, vulnerable population. We took Nordhaus’ model, tweaked the assumptions, and computed the consequences for optimal climate policy. The result (Budolfson et al. 2018) confirmed our worry that RICE’s recommendation might be too optimistic about economic development. If we can expect climate change to harm many poor people, then we should do even more to prevent it now than RICE originally recommended.

One of Nordhaus’ contributions was to put his model on the internet. You can download it, too, and investigate your own version. Many Nobel prizes have been given for work that was done and over with long ago. Nordhaus’ prize, for providing tools to understand climate policy, is for critical but unfinished work in progress.

r.i.c.e.