The (true) cost of a low-carbon future

Figure 1 shows that our measures of GDP may be significantly higher today than they would be if we incorporated the cost of carbon correctly (that is, subtracted the social value of carbon emissions from GDP). And over time, the cost rises, suggesting that—absent any policy change—a measure of GDP growth that includes the cost of greenhouse gas emissions would be lower than GDP growth estimated using current methods, which take no account of those emissions.³ So official GDP is overly optimistic about our current level of production, and likely to be overly optimistic about how fast the economy grows in the future.

Some key consequences of inaccurately measuring GDP

The overestimation of GDP and national income leads to two further problems:

1. We consistently overestimate productivity. Productivity measures are based on GDP, and if true GDP growth is slower than measured GDP growth, productivity growth is slower as well.
2. Statistical agencies and private business firms will incorrectly measure the return to capital and profitability. In the past, companies’ calculation of the return on investment did not take the cost of greenhouse gas emissions into account; future investments may be made on a different basis.

Lower-measured GDP growth as the economy adjusts to a low-carbon-output world will therefore show up in the form of lower labor productivity growth, a decline in the return to capital, and a fall in corporate productivity. To be clear, correctly measured, these metrics may not necessarily slow (and may even accelerate). But official data, if it continues to reflect current methods, will show a slowdown in labor productivity growth. This will create an impression that the economy is performing poorly. Analysts—and, more importantly, citizens—will have to be aware of this problem to avoid being misled about the impact of climate change remediation.

The problem goes beyond official data. Businesses will experience declining profitability even as they make large investments in plant and equipment to reduce greenhouse gas emissions. But at least some of the decline in profitability will actually reflect the correct internalization of the costs of greenhouse gases. The real problem is that, in the past, profitability—ignoring the costs of greenhouse gas emissions—appeared higher than the true level. The earlier high profitability, however, while coming in the form of actual cash, was really something of a mirage since businesses did not pay the full social costs of production.

Another related problem involves valuing the capital stock. Much of the world’s existing capital—buildings, machines, and even knowledge—was created based on ignorance of the true costs of climate change. As those costs become internalized, existing capital will prove to be less valuable than users had believed. In essence, capital depreciation is likely to be very fast over the period of adjustment to a world of reduced greenhouse gas emissions. The depreciation will be an artifact of the speed and types of policies taken and represents movement from a false overvaluation of capital to the true, lower valuation that takes into account the cost of climate change.

One example—albeit slightly extreme—is the much-debated possibility of a reversal of the Gulf Stream. By one estimate, this could lower the average temperature in the United Kingdom by 3.4 degrees (Celsius).⁴ That would require retrofitting much of the stock of buildings in the country to continue to be useful in the colder climate, essentially reducing the value or depreciating the unretrofitted capital stock and requiring a huge investment simply to keep the capital producing at the current level.

Something similar happened on a smaller scale when oil prices tripled in the early 1970s. The global capital stock, which had been built under the assumption of cheap oil, essentially depreciated suddenly because it was no longer as profitable as it had been. Over the next decades, older capital (for example, “gas guzzling” automobiles) was replaced with newer, more energy-efficient capital, and very likely at a faster rate than had the oil shock not occurred.

Misleading signals

The world’s adjustment to reduced greenhouse gas emissions is likely to be messy and controversial. Misleading data could make the debate even more difficult. Policymakers and citizens will need to interpret economic data carefully over the coming years.

Expect the following:

1. Per capita GDP growth may appear to slow, and measures of consumption may appear to slow further as capital is required to retrofit the economy for a world of lower greenhouse gas emissions. Claims that this is a slowdown, or possibly even a decline, in the standard of living should be evaluated carefully; unless we include a measure of the artificial inflation of our standard of living in the past, comparing per capita GDP from the past with per capita GDP in a world that accounts for climate change is an example of that famous problem of comparing apples and oranges.
2. Similarly, slower labor productivity growth is not a problem if it reflects the gradual introduction of correct valuation of production. Workers won’t become less productive—their productivity will more correctly reflect the costs of greenhouse gases.
3. Expect a period of time when corporate profitability is low and investment spending is high. If it had been measured correctly, corporate profitability would have been lower in the past than everybody thought—a more accurate reflection of the reality. Similarly, low (by current standards) returns to capital may well be accompanied by high investment. This reflects the need to move to the new, correct, and efficient economic equilibrium.

Unfortunately, the debate over climate change and the need to reduce greenhouse gas emissions has incentivized a small number of analysts to provide intellectual support to those who do not wish to accept the lower profits and economic change required. Those analysts are likely, over the next decade, to point to lower GDP growth, low productivity growth, and low profitability, as reasons why the United States should reverse the measures to fight climate change, like those in the Inflation Reduction Act. Astute observers should realize the weaknesses of the data underlying these arguments and recognize that the methods we’ve used in the past to measure the economy haven’t taken the cost of climate change into account.