Climate change causes global economic decline

Assessing the impact of climate change is, at best, an extremely complex exercise with uncertainty about both the degree of future global warming and the subsequent impact on global activity. There are clearly some benefits as well as costs as the planet warms. There is also the unknown of how technological progress will respond and potentially alter the path of global warming. Any assessment also involves taking a very long-run view, well beyond that normally used by financial market participants. However, increasing awareness of the issue means there is a growing demand for a view from shareholders who are either concerned about how the companies they own impact the environment, worried about the effect of climate change on the value chain of those companies, or a combination of both. In response, the academic community is leading the way in an attempt to encourage financial market participants and governments alike to change collective behaviour so as to mitigate the costs of global warming. Drawing on this work, we discuss the effect climate change is likely to have on growth and inflation, followed by an exploration of different climate loss functions which attempt to estimate the economic cost associated with a given increase in temperature. Finally we conclude with possible policy responses. The effect on growth & inflation Despite there being winners and losers, increasing temperatures will be negative for global activity overall The overall aggregate effect of climate change on economic growth will most likely be negative in the long run. Although there will be winners and losers from climate change at varying levels of warming, the impact of rising temperatures will be widespread, in part due to the financial, political and economic integration of the world's economies. Global warming will primarily influence economic growth through damage to property and infrastructure, lost productivity, mass migration and security threats. The balance between winners and losers turns increasingly negative as temperatures rise. Global warming is expected to increase the frequency and severity of extreme weather events, bringing with it property and infrastructure loss. The likes of Hurricane Sandy, which flooded much of New York, are prime examples of the economic damage such extreme weather events can cause. Rising sea levels will also likely harm economic output as businesses become impaired and people suffer damage to their homes. Whilst the initial economic response to recover this damage may be positive for GDP (when it is possible to do so), once it is recognised that such events are a permanent feature of the environment, the world economy faces an extreme challenge. Many will find that it is not worth replacing capital stock unless measures can be taken to prevent future damage, or there is an opportunity to move the business to safer ground. At best, this could involve a short period of disruption as businesses relocate; at worst, a permanent loss of capital stock and output. As the temperatures continue to climb, the damage will become increasingly permanent. Climate change is likely to reduce the capital stock and productivity in the world economy Using a production function (Figure 1), we can demonstrate the likely effect climate change will have on output. If we assume less capital stock is available due to the damage inflicted from climate change, we would see a fall in the productive capacity of the world economy. This would translate into a downward shift in the world production function as each unit of labour produces less output. Lower labour productivity may not just occur due to a lower level of capital stock, however. Higher global temperatures may affect food security, promote the spread of infectious diseases and impair those working outdoors. Such factors are likely to cause greater incapacity and social unrest and as a result will reduce both the effectiveness (productivity) and the amount of labour available to produce output. This effect can also be expressed as a supply shock through a supply and demand framework (Figure 2). Global warming is likely to contract supply at any given price and result in a backward shift of the supply curve (from S1 to S2). As the diagram demonstrates, this will result in a lower level of output (Y2) and, as we discuss in the next section, a higher price (P2). [Figure omitted]. There is also an opportunity cost to be considered. The above analysis is based on a ceteris paribus1 argument whereby the world's population is seen not to respond to climate change. It is probable that over time, preventative measures such as flood defences are put in place in order to avoid the costs of climate change. Whilst this may reduce the long-term economic consequences, there is likely to be a short-term economic cost to this action as resources are directed away from more productive uses. According to Mendelsohn (2013), the biggest threat climate change poses to economic growth is from immediate, aggressive and inefficient mitigation policies. The process of adaptation and mitigation will require a temporary economic transition from consumption to investment, with the argument being that the transitional costs are small relative to the cost of inaction. Stern (2006) estimates the costs of mitigation to be in the region of 1% of global GDP per annum by 2050. However, we would argue that as the costs of mitigation rise, budget constraints are likely to become increasingly important. Governments’ may be unable to raise the capital necessary to build adequate defences, for example. Inflation is likely to rise as shortages emerge, particularly in agriculture The above supply and demand diagram not only shows a reduction in output, but an increase in the general price level as a result of global warming. This leads us onto the possible inflationary effects of global warming on the world economy. Agricultural yields are sensitive to weather conditions and as our climate becomes ever more extreme, more frequent droughts may reduce crop yields in areas where food production is vital. Higher global food prices will likely thus squeeze consumers’ income in the process. We must acknowledge that these effects will be partially offset as other regions becoming more suitable for crop production and new drought resistant crops are developed. However, in aggregate, and as the level of warming becomes even greater, food price inflation should rise. Rising inflation may also materialise through reduced land availability. The surge in global temperatures may eventually cause some areas of the world to become uninhabitable and with this will come mass migration. Alongside the political and socioeconomic implications of these moves will be higher demand for an ever decreasing amount of land. In essence, the world's population will be forced to live in an increasingly concentrated space. In similar fashion to food inflation however, this effect will also be moderated by some areas of land becoming more habitable (see regional effect section below).