UK: Climate change and the macro-economy

By Laura Canevari

Through a critical review of the literature, Sandra Batten of the Bank of England reflects on the key theoretical and modelling challenges facing central banks when trying to analyse macroeconomic risks derived from climate change. The paper explores how climate risks, both physical and transitional, are transmitted to the macroeconomy through either unpredictable economic shocks or as a result of more predictable longer-term impacts. The review offers valuable insights pertaining current challenges and limitations of modelling the macroeconomic impacts of climate change and the ways forward to improve existing modeling techniques.

In this article, we highlight key insights on the effects of physical climate risks on macroeconomic factors and the ways in which these impacts are assessed. This information will be of interest to any financial institution looking to incorporate climate change considerations into their existing macroeconomic models.

Supply and demand impacts of extreme events and gradual global warming

It is important to note that climate impacts can be caused by either gradual (chronic) or extreme (acute) climatic events. Gradual refers to incremental changes in climate (such as changes in temperature or rainfall), whilst extreme encompasses extreme weather events such as hurricanes and drought. From a macroeconomic standpoint, both gradual and extreme climatic events can generate effects in both demand and supply.

Supply and demand impacts caused by gradual global warming include:

• Demand side
  1. Changes in consumer choices
  2. Changes in labour productivity and migration
• Supply side
• Tradeoff between reductions in GHG emissions and lower short-term growth

Supply and demand shocks caused by extreme events include:

• Demand side shocks (affecting aggregate demand), such as:
  1. Impacts to households reducing private consumption
  2. Reduced investments due to damage of physical and financial assets
  3. Trade disruptions
• Supply side shocks (affecting the productive capacity of the economy)
• Shortage of inputs and natural resources
• Damage to capital stock and infrastructure

Whilst it is possible to describe these effects conceptually, in practice, it is very difficult to quantify these impacts in monetary terms.

The macroeconomics of gradual global warming

Gradual global warming is likely to affect the productive capacity of the economy through a number of channels, such as through impacts to natural capital (e.g. natural resources), physical capital (e.g. infrastructure) and human capital among others. Integrated Assessment Models (IAMs) are the main analytical tool used to assess the damage posed by global climate change to the economy. As highlighted by Batten, IAMs suffer from a number of severe limitations including their broad scope and simplified representation of individual climate and economic components. Despite these limitations, IAMs remain the best available tool to integrate the effects that different GHG emission trajectories exert on changes in temperature. In doing this, IAMs give an indication of the corresponding the effects of climate change (as driven by temperature) on economic variables such as productivity output and consumption.

Many of the IAMs models currently available focus on the relationship between temperatures and output per capita. However, depending the approach taken, models may reach different conclusions. Some, for example, suggest that a 1°C rise in temperature in a given year can reduce economic growth in that year by 1.1 % (see Dell et al., 2012). Others suggest that for each 1°C increase in daily average temperature above 15°C, productivity declines by roughly 1.7%. Additionally, studies have also looked at the effects of increased temperatures on the labour force. For example, Graff Zivin and Neidell (2014) stipulate that at daily maximum temperatures above 29°C, workers in industries with high exposure to climate reduce daily time allocated to labour by as much as 1 hour, whereas climate-insulated industries do not suffer labour-market impacts.

The macroeconomics of extreme weather events

Impacts from extreme weather events can be direct and indirect. Direct impacts (both market and non-market losses) include effects on mortality, morbidity and damage to fixed assets and infrastructure. Indirect impacts are losses not caused by the disaster itself, but as consequence to impacts on the economy. Indirect impacts can be felt in the long term and may include damages such as the depreciation of the value of physical assets as well as affecting the longevity of infrastructure.

Most of the literature has focused on the short-term effects of extreme weather events and natural disasters. Whilst information on long-term effects is scarce, there are three different hypotheses describing these effects on economic output:

• The “creative destruction” hypothesis: Extreme events generate demand for goods and services (e.g. for reconstruction) and can thus lead to a period of faster growth –
• The “recovery to trend” hypothesis: Extreme events slow down the economy in the aftermath of an extreme event and productivity eventually returns to its pre-disaster state
• The “no recovery” hypothesis: Extreme events destroy productive capital and/or durable consumption and result in the slow-down of the economy.

Although there are studies in support of each of the three hypotheses, the “no recovery” hypothesis is supported by the largest number of empirical studies. Under this scenario, the continued reallocation of capital investment towards adaptation measures (and the use of capital in repair and reconstruction investments rather than in innovation and knowledge transfer) could further undermine economic growth, leading to lower output growth (see Pindyck, 2013). It is worth noting that unlike IAMs used to predict future impacts of gradual global warming, most studies on extreme events lack a forward-looking outlook.

Conclusions and future areas of research

Batten’s review offers valuable insights into the different channels for transmission of climate impacts into macroeconomic outcomes, either through gradual climate change or extreme weather events. The review also reflects on the difficulty of measuring such impacts, especially when trying to capture the effects of gradual changes in the climate.

In light of the increasing need to disclose climate change impacts, it is important to promote the use of techniques able to quantify its macroeconomic impacts and to further advance the development of more refined methods. For this purpose, three key suggestions to improve economic modelling of climate change are proposed:

• Use recent empirical studies to inform modelling choices for the climate damage function
• Inclusion of predictive outputs on the occurrence of extreme events in macroeconomic models (both in short and long-term run).
• Studies that account for both the effects of gradual climate change and extreme events are currently missing

As noted by the author, there is strong potential to design a modelling framework that takes complex global linkages into account and projects near-future climate damage. There is also scope for the construction and calibration of disaggregated multi-sector economic models that include more detailed descriptions of climate changed induced damage. By monitoring and tracking current climate impacts in their activities, financial institutions will be able to improve the calibration of these models and tailor them to their internal use.

Finally, it is important to take climate policy into account when conducting economic modelling of climate risks, as climate policy should not be seen in isolation and it feeds back into the climate system. Rather, it should be considered an integral part of the broader policy agenda to promote economic growth.