Is the Economic Impact of Climate Change Underestimated?

As the effects of 1-2 degrees Celsius of warming are already being felt by economies and communities around the world, two economists are suggesting the previous understanding of climate change’s financial impact may be severely underestimated in a May 2024 working paper published by the National Bureau of Economic Research (NBER).

Source: Intergovernmental Panel on Climate Change 

Although global averages have yet to exceed the 1.5 C threshold—sitting above 1 C currently—some parts of the world are already experiencing temperature increases well above that limit. As seen in the figure above, as global averages approach a 1.5 to 2 C rise, some regions can experience fluctuations of up to 10 C! It is estimated that roughly 20% of the world’s population is already living in a region that experiences temperatures above 1.5 C for at least one season of the year. 

Aside from the obvious threat of heatwaves, these communities are also dealing with a rise in droughts, extreme precipitation events, and a loss of biodiversity, both on land and in waterways. These impacts, combined with the human-centric effects of climate change (rise in heat-related illnesses, food insecurity, etc.) present real risks to local and national economies as well; previous estimates forecasted a potential decrease of 0.3% to 2.6.% of the US GDP by the year 2100, depending on the level of global warming assumed in the model. Globally, a summary of studies found a 1 to 3% decrease in global economic output was to be expected for each 1 C increase in global temperature, a potential impact in the 10s of trillions of dollars.

However, despite the significant scale of these numbers, economists Adrien Bilal and Diego Känzig suggest these estimates are not painting a true picture of global warming’s economic reality based on their published findings.

Taking a Global View on Global Warming

Using a model that correlated global temperature data with local/national climate and financial records, the NBER paper found that a 1 C variation in global temperature will likely cause a peak reduction of 12% in global GDP—a value that greatly exceeds the previously reported range of 1 to 3%.

Unlike previous studies, the researchers wanted to move away from focusing solely on datasets for individual countries when attempting to assess climate’s impact on economic systems. Instead, the team aimed to quantify the effect that global temperature variations, focusing on historical “shocks,” defined as deviations from the long-term trends in global mean temperature. This metric was chosen as opposed to analyzing the global mean temperature itself as there is a positive, yet unfortunate correlation between global GDP and global temperatures over the last century (due to rise in industrialization and productivity). Extreme temperature events were isolated and the short to mid-term response from the global economy following the shock was analyzed. Using this information, in combination with additional controls to correct for abnormal events (recessions, oil crisis, El Nino cycle, etc.), a forecast was developed to estimate the short to mid-term economic impact of an additional 1 C of global warming.

Researchers did not want to rely solely on country-level data, as they suggested models only considering annual variations across local datasets fail to properly forecast the prevalence of extreme climatic events (local temperature shocks, extreme winds, extreme heat, and extreme precipitation), whose strength and frequency are products of global climate. They argue the focus on local data filters out these common global risks by downplaying the forecast of these weather abnormalities. They use the above figure to demonstrate the increased impulse response of extreme weather events for the years following observed global (blue band) and local temperature shocks (red band). Across these four selected events, it is clear that global temperature variations suggest a higher and more sustained increase in extreme events than local shock events. It is this “blindspot” that the researchers attempt to account for in this model, ensuring that global economic patterns are compared with global, not local, temperature events.

Asides from commentary on the heightened economic risk of climate change, the paper also highlighted the persistent nature of temperature shocks on the global economy. As seen above, although the GDP impact peaks at around 12% close to 6 years after an increase of 1 C of global warming, the negative impact on GDP can still be realized as much as 10 years out.  To put these findings into perspective, the duo highlight that this sort of economic fallout is something to be expected during a severe banking or financial crisis.

Bilal and Känzig confirm their model by running a similar analysis focusing solely on local, country-level shocks. The above figure demonstrates the stark comparison between the methodologies, with the local model forecasting an economic impact that aligns with previous estimates of a GDP decrease between 1 to 3% for each 1 C of global warming. The gap between the global and local models is quite significant, especially when considering the mid-term effects of climate change; it’s this variation that the researchers believe is capturing the effect of extreme climate events that are properly accounted for when considering global temperature shocks.

Aside from the increased effect on global GDP, the report also highlighted what their findings would mean on other economical components of climate change. One metric that would change considerably with this paper’s conclusions is the Social Cost of Carbon (SCC), a value that attempts to quantify the marginal costs of emitting an additional tonne of carbon. Recent estimates available from the US Environmental Protection Agency and Environment Canada place this price at around US$180-190/tonne of CO2. However, if the true cost of global warming falls in line with the paper’s model, their results would imply this should inflate to around US$1,056/tonne, a 5x increase! This value corresponds to a loss in welfare of about 31%, which the researchers liken to the impact of having a major war fought indefinitely.

The recent reporting of these findings may mitigate the impact they have on the social and financial valuation of carbon emissions. However, considering that the model’s results align well with earlier, more conservative estimates (based on country-level climate data) of climate change’s financial impact, and the significant negative trends that emerge when factoring in global climate variations, these conclusions may prove to be revolutionary. Regardless, whether or not these results prove to be a useful forecast in the long-term, they are a stark reminder of the complex and existential issue of climate change, the importance of working together as a global community to continue reducing our emissions, and their impact on other areas of society.