think climate. think change.
Department of Climate Change
Australian Greenhouse Office, 2004
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1. This study is one of two complementary studies commissioned by the Australian Government, through the Australian Greenhouse Office (AGO), on the impact costs of climate change:
2. Climate change due to the enhanced greenhouse effect is likely to be the most significant environmental issue confronting the global community in the twenty first century. Of all industrialised countries, Australia is one of the most vulnerable to the impacts of climate change. This reflects Australia's already variable climate, poor soils, vulnerable ecosystems and high proportion of population living in coastal areas. Thus the potential impacts of climate change and the need to develop appropriate adaptation strategies are now important considerations in the context of national, state and local government responses to the issue.
3. The economic costs of climate change mitigation are relatively well understood, as are the sectors and industries most likely to be affected by mitigation policies and measures. By contrast, the economic costs of climate change impacts are not well understood. It is essential that economic assessments of climate change are framed in the context of a sound appreciation and understanding by decision-makers of all of the potential costs and benefits (i.e. net benefits) associated with climate change and climate change response. Once the costs of climate change impacts and net benefits of adaptation strategies are better understood, decisions can be made about the most appropriate combination of mitigation and adaptation measures.
4. Welfare economics provides the most appropriate economics framework for costing the impacts of climate change. When extended to address externalities, uncertainties, equity etc, welfare economics can be used to place a dollar value on most of the impacts of climate change, drawing on a consistent and flexible set of methods and tools.
5. It is crucial that the objectives and scope of an economic assessment of the impacts of climate change are fully defined prior to any assessment being undertaken and that these reflect the problem at hand. The objectives and scope of the assessment are a function of the decision problem, which in turn relates to:
6. Within the welfare economics framework, there are two basic levels of analysis that can be used to assess the net costs of climate change impacts:
7. The economic valuation techniques discussed in Section 3 provide flexible and generally straightforward approaches to estimating the costs of climate change impacts on an industry or market, or for assessing the costs and benefits of alternative adaptation options.
8. These techniques are most appropriately applied in the context of local or regional scale climate change impacts, disaggregated by sector or market. The use of the techniques in isolation (sometimes referred to as 'bottom-up studies) is predicated on an assumption that that any one climate change impact will not have large, indirect (non-marginal) impacts, affecting the prices of a range of goods and services that flow through the macro-economy.
9. Economic valuation techniques can generally be grouped into two major categories - methods that use 'directly observed market behaviour' and methods that draw upon 'hypothetical market behaviour' (see Chart ES. 1):
- 'direct markets', which will cost climate change impacts using the market price of the affected good or service which has been obtained in a conventional market; and
- 'indirect markets' will cost climate change impacts by observing behaviour in surrogate markets for an affected good or service.
| Method | Directly observed market behaviour | Hypothetical market behaviour |
|---|---|---|
| Direct market | Market price Preventative expenditure/ restoration cost |
Contingent valuation |
| Indirect/surrogate market | Travel cost Hedonic pricing |
Choice modelling |
Source: Adapted from Tietenberg 2000.
10. Once the net costs of climate change impacts have been assessed for a given market or sector, it becomes possible for decision-makers to value the benefits of adaptation to those impacts. The gross benefits of adaptation to climate change can be quantified in terms of the reduced costs of the impacts of climate change. By assessing the resource costs of different adaptation options (policies or programs) then it becomes possible for the decision maker to determine which adaptation option (if any) offers the greatest benefits relative to costs.
11. There are two main techniques available for assessing the relative costs and benefits of alternative adaptation responses (measured solely or principally in monetary terms):
A third available technique for assessing alternative adaptation options, in the absence of full information on monetary costs and benefits, is multi-criteria analysis.
12. Where the impacts of climate change on a market result in indirect economic impacts or economic flow on effects throughout the economy, or where the impacts of climate change are being assessed for number of markets or industries, then general equilibrium analysis should be used.
13. General equilibrium analysis accounts for the inter-sectoral reallocation of resources that could occur as a consequence of climate change. It accounts for the effects on the input-output structure of the economy; effects that cannot be captured through partial equilibrium analysis. Thus, it is appropriate to use general equilibrium analysis when the impacts of climate change (or adaptation policies and measures) are likely to simultaneously affect many sectors or markets and factor prices and incomes.
14. The two main types of models that can be used to undertake general equilibrium analysis are input-output (IO) models and Computable General Equilibrium (GCE) models.
15. Computable general equilibrium (GCE) models are now commonly used for general equilibrium analysis. GCE models are models of the total economy, covering all sectors of the economy and the interactions between those sectors. Essentially they simulate markets for factors of production and products across the whole economy using systems of equations specifying supply and demand behaviour across the different markets. The models are designed to examine the welfare changes (measured in terms of GDP or GNP) arising from an external 'shock' impacting on price.
16. A key strength of CGE models is their ability to model economy-wide effects of policies and other external shocks, rather than just on discrete, individual markets or sectors. Another important characteristic of many (although not all) recent GCE models is that they are dynamic - that is, they include relationships between variables in the model at different points in time. Thus they do not assume a static baseline.
17. GCE models could potentially be used in several ways to model the impacts of climate change: These include:
18. The choice of model and the way in which it is used will depend very much upon the climate change impact to be assessed or the adaptation policies or measures of interest.
19. Integrated assessment (IA) seeks to combine socio-economic and biophysical assessments of climate change. Integrated assessment can employ a range of methods including scenario analysis, qualitative assessment and computer modelling. Many integrated assessment models of global climate change have been developed over the past decade or so, most of which have a focus on mitigation responses and costs at the national or international level, although recent 'bottom-up' IA models have sought to capture the individual direct effects of climate change at the local or regional level.
20. The challenge for IA is to make use of the spatial and sectoral detail of 'bottom-up' models, while ensuring that:
21. There is a great deal of uncertainty associated with costing climate change impacts. Dealing effectively with this uncertainty will be crucial to effective economic assessment and decision-making on the issue.
22. Uncertainty can be defined as poor knowledge of the likelihood that an event or state-of-nature will occur. Uncertainty can constitute anything from 'confidence just short of certainty' to 'speculation'. Most if not all decisions involving the assessment of impacts or adaptation options are likely to involve uncertainty. The range of uncertainty associated with climate change increases as we move from biophysical to economic impacts, with very wide bands of uncertainty associated with the economic costs of climate change impacts. This high level of uncertainty is due often to a poor understanding of the interaction of factors operating in socio-economic systems and aggregated uncertainty with socio-economic systems being based on biophysical systems.
23. Risk can be defined as the likelihood that an event or state-of-nature will occur and its (undesirable) consequences. In the context of climate change impacts, risk is often discussed in terms of:
24. A range of methods are available for quantifying the effect of uncertainty and risk on cost estimates of the impacts of climate change including:
25. If decision-makers have a good knowledge of the probability of an event or state-of-nature occurring as a result of climate change, then there are tools available to aid decision-making under conditions of risk and uncertainty. These include:
26. If decision makers do not have good knowledge of the probabilities of states-of-nature occurring, then predefined decision rules can be applied to the expected net benefits of different adaptation options. The main rules applied by decision theorists are:
A major potential difficulty with applying any of the tools discussed above arises when not only can probabilities not be assigned to outcomes, but when outcomes cannot even be known.
27. Discounting is the usual method used to add and compare costs and benefits that occur at different points in time. The method involves summing across future time periods net costs (or benefits) that have been multiplied by a discount rate, typically greater than zero. If the discount rate is zero, then equivalent costs (or benefits) in each time period are valued equally. If the discount rate is infinite then only the current period is valued. Thus the higher the discount rate, the less the value attached to future costs (or benefits). The rationale behind discounting is that individuals and businesses attach less weight to a benefit or cost occurring in the future than they do to the same benefit or cost incurred now.
28. Where there are no intergenerational issues other than dollars, it is generally appropriate to apply a high discount rate, reflecting the opportunity cost of capital. When there are intergenerational issues however, particularly those involving potentially irreversible environmental impacts, then society arguably has a 'duty of care' to future generations to avoid those adverse consequences. In this circumstance, it may be appropriate to apply a low or zero discount rate to future benefit streams (e.g. the avoidance of irreversible environmental impacts).
29. There is general agreement on the need for sensitivity analyses to be applied to economic assessments of the costs of climate change impacts, drawing on a wide range of discount rates. Rates may need to be varied so as to take account of the nature of the assessment (i.e. assessment of the costs of impacts vs assessment of costs of mitigation vs assessment of the benefits and costs of adaptation) and/or possible changes through time to the factors influencing discount rates such as interest rates and economic growth rates.
30. A concern expressed about the application of welfare economics to valuation is that it does not deal well with equity issues. This is especially relevant to climate change analysis since the impacts of climate change are unlikely to be evenly distributed, either between regions or between income groups.
31. One possible approach for addressing the costs or benefits of climate change that impact upon different income groups, either within a country or region or between regions, is through weighting of estimated costs and benefits with an 'equity factor' according to who has been impacted. Another potential approach to addressing distributional issues is to document the distribution of climate change impacts. This could be done through the use of a distributional matrix which sets out the costs of climate change impacts or costs and benefits of adaptation options according to income group or region.
32. Environmental values can be classed into several types of values, the two main categories used by economists being 'use' and 'non-use' values.
33. There is considerable debate as to whether it is possible to place a monetary value on non-use values. One argument is merely technical - the argument centring on issues such as survey design, bias and whether a 'hypothetical market' can be made to closely approximate a 'real market'. Another argument is more philosophical - the idea that meaningful monetary values exist at all for an environment attribute; that value is equated with price, generated by the interaction of supply and demand.
34. A framework for assessing the economic costs of climate change impacts has been set out in the preceding sections of this report. This framework, encompassing major elements, methods and tools, is synthesised in Chart ES.2.
35. This report has provided an overview of the key issues relevant to economic assessment of the impacts of climate change and the methods and tools that can potentially applied to costing those impacts. Before undertaking any detailed economic assessment of the impacts of climate change in the future, the AGO and other relevant agencies will need to carefully consider the basis of any future assessments by identifying:
36. Further, upon proceeding with an economic assessment of the impacts of climate change in the future, decision-makers should be aware that the methods and tools discussed in this report are decision-support tools. As such, the outcomes from an assessment of the costs of climate change impacts can provide useful guidance to the decision-maker. However, the value of the economic assessment to the decision-maker will depend not only on the robustness of the data used and methods applied in the assessment, but also on the transparency of assumptions used in the analysis. This last point is particularly important given the uncertainties and risk associated with the climate change issue.
Chart ES.2: Major elements of a framework for costing the impacts of climate change
