Unit 8 Economic dynamics: Financial and environmental crises

8.12 Prudential policies to address fundamental uncertainty about environmental tipping points

marginal social cost, MSC

The marginal social cost (MSC) is the cost of producing an additional unit of output, including both the cost for the producer (marginal private cost) and the costs imposed on others (the MEC). MSC = MPC + MEC.

marginal social benefit, MSB

The marginal social benefit (MSB) is the benefit of the production or consumption of an additional unit of a good, including both the benefit for the producer or consumer (marginal private benefit) and the benefits conferred on others. MSB = MPB + MEB.

Environmental policies are often designed like other governmental measures: the ‘right’ level of a carbon tax, for example, would maximize total well-being of a population, taking into account the relevant trade-offs. To do this the policymaker would use the principles of ‘doing the best you can’, focusing on marginal social costs and benefits, as illustrated for some environmental problems in Unit 10 of the microeconomics volume.

The policymaker would choose the carbon tax that would equate the marginal cost of the emissions abatement to the marginal benefits of mitigating climate warming, nudging the status quo stable equilibrium towards a more preferred outcome. However, when human interactions with the biosphere include a tipping point between an environmentally sustainable equilibrium and a radically degraded environment, this approach could be catastrophic. The reason is that there is a possibility of large and possibly cataclysmic changes away from the status quo equilibrium that may result in passing beyond the tipping point, after which adverse changes become virtually impossible to reverse.

In the presence of environmental tipping points, then, the problem shifts from achieving the best sustainable equilibrium (assuming that that is our future) to ensuring that a sustainable equilibrium will exist and that the process of runaway environmental collapse will not be set in motion.

To understand the difference in policy approach, imagine that you are standing on a hill above a cliff, seeking the best spot for the view of the countryside. If that spot were next to the cliff you might then go and stand there. But now add the fact that it’s very windy and you are being blown about a bit, sometimes losing your balance, and that as the sun has gone down you are not really able to make out exactly where the cliff is. You would prudently decide not to stand at the very best spot for the view, and might back away from the cliff. Scenic viewpoints such as this in public recreational areas often have guard rails to prevent people from standing too close to the cliff (even if that is truly the best spot for the view), where a mistake or inattention might be disastrous.

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The Blue Mountains, New South Wales, Australia, 1915.

The need for something akin to guard rails in environmental policy arises from two similarities with the hill-and-cliff story:

• Fundamental uncertainty about the location of the tipping point and the consequences of crossing it; and
• The possibility of catastrophic—possibly life-ending—consequences setting in motion irreversible positive feedbacks of environmental collapse.

We are familiar with uncertainty in our everyday lives. In some cases, we have information that helps us make decisions: it may rain or not, but the forecaster tells us the likelihood of rain. We may flip a coin not knowing whether heads or tails will come up, but we know that with a fair coin the chance of heads is 50-50. It is much more difficult to make decisions when we have no idea of the probability that some future event will occur.

When we want to distinguish between these two situations, economists use the term risk to describe cases where we know, or can reasonably estimate, how likely an event in the future is, and fundamental uncertainty for cases in which we do not know even the probability that it will happen. In a situation of uncertainty, we cannot do the elementary calculations by which economists summarize the expected costs and benefits of a policy, as these calculations require knowing the probability that some event or situation will occur if the policy is implemented.

Fundamental uncertainty will occur in any situation like that described in our model of environmental tipping points. Societies that have survived over long periods have avoided environmental collapse, remaining at or near a stable and sustainable equilibrium. The result is that existing societies do not have experience with the process of irreversible environmental collapse, so we have little information which could reduce our fundamental uncertainty.

Our knowledge of the world beyond an environmental tipping point is a bit like the knowledge Europeans had of the western hemisphere before 1500. They knew (from Viking legends and other sources) that it was there, but they had no way of mapping it. The ‘new world’ was fundamentally uncertain to them.

Catastrophic consequences are important because we have difficulty comparing these ‘costs’ with the kind of cost and benefit analysis that we routinely do in everyday decision-making. We have a sense of how ‘bad’ a rainy day at the beach is: uncomfortable but not as bad as a broken leg. But how do these compare with the end of humanity as a cost to be avoided, even if the probability is very small?

prudential policy

A policy that is prudent in that it places a very high value on reducing the likelihood of a disastrous outcome, even if this is costly in terms of other objectives foregone. Such an approach is often advocated where there is fundamental uncertainty about the conditions under which a disastrous outcome would occur.

Fundamental uncertainty and the possibility of catastrophic consequences challenge the way that economists compare the benefits and costs of various policies. The conventional way is called cost–benefit analysis and the objective is to choose from a range of different projects (for example, in a programme of government-funded hospital building) by comparing marginal social benefits and marginal social costs, as shown in Section 10.2 of the microeconomics volume. An alternative (or additional) policy approach to cost–benefit analysis is termed prudential policies (also termed guardrail policies).

In the case of summer sea ice, for example, the aim of prudential policies would be to keep the planet cool enough to avoid a catastrophic collapse of the sea ice that would, if a few unusually hot years resulted in substantial loss of the sea ice, push the system past the tipping point. This would mean sustaining an EDC for summer sea ice high enough so that the stable ample sea-ice equilibrium, G, in Figure 8.27 is sufficiently distant from the tipping point T.

Some guardrails indicating what this would require are provided by the international consensus achieved in the Paris agreement of 2015 (the Paris Accord) on the scientific evidence that global temperature rise should be kept to well below 2 degrees Celsius above pre-industrial levels in order to prevent potentially catastrophic effects on human life on earth.

The economist’s job is then to design the most cost-effective policies to keep within the guard rails. In the model of summer sea ice, this can be translated into designing policies to prevent the EDC from shifting down and narrowing the gap between the stable and unstable equilibria so much that a shock of the size encountered in ‘normal times’ would be enough to produce the runaway processes to the no-summer-sea-ice equilibrium.

In the absence of these and similar guard rail policies, the downward shift in the environmental dynamics curve (EDC) due to ongoing climate warming risks setting off a catastrophic positive feedback process leading to accelerating loss of ice, and contributing to additional warming. This in turn will reinforce the warming trend in the other cases where positive feedbacks may be strong as in Figure 8.28: deforestation, forest fires, greater use of air conditioning, melting permafrost, and warming tundra soil. Each of these could possibly set in motion a runaway dynamic process leading to greater warming, in ways similar to the disappearance of the Arctic sea ice.

But policies to limit the process of global warming can retard or reverse this downward shift in the sea ice EDC and in the similar EDCs for the other cases illustrated in Figure 8.26. We consider one example in the next section.