Climate Change and the Financial Crisis

1. Climate Change and the Financial Crisis Klaus Hasselmann Max Planck Institut for Meteorology, Hamburg, and Global Climate Forum Workshop on Coupled Climate-Economics Modelling and Data Analysis ENS, Paris, 22-23 Nov 2012

2. Or: Where do we stand in Integrated Assessment modelling today? • four years after the financial crisis • four years after complete stagnation in international climate policy

3. Climate policy impacts of the financial crisis before Nov 2008 after

4. Climate policy impacts of the financial crisis before Nov 2008 after High expectations in UNFCCC 15, Dec 2009 Copenhagen

5. Climate policy impacts of the financial crisis before Nov 2008 after High expectations in UNFCCC 15, Dec 2009 Copenhagen 2007, Nobel peace prize, IPCC and Al Gore

6. Climate policy impacts of the financial crisis before Nov 2008 after High expectations in UNFCCC 15, Dec 2009 Copenhagen 2007, Nobel peace prize, IPCC and Al Gore 2007, Stern Report

7. Climate policy impacts of the financial crisis before Nov 2008 after High expectations in UNFCCC 15, Dec 2009 Copenhagen 2007, Nobel peace prize, IPCC and Al Gore 2007, Stern Report Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

8. Climate policy impacts of the financial crisis before Nov 2008 after UNFCCC 15 failure in Copenhagen High expectations in UNFCCC 15, Dec 2009 Copenhagen 2007, Nobel peace prize, IPCC and Al Gore 2007, Stern Report Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

9. Climate policy impacts of the financial crisis before Nov 2008 after UNFCCC 15 failure in Copenhagen High expectations in UNFCCC 15, Dec 2009 Copenhagen Pre-occupation of policy-makers with financial crisis 2007, Nobel peace prize, IPCC and Al Gore 2007, Stern Report Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

10. Climate policy impacts of the financial crisis before Nov 2008 after UNFCCC 15 failure in Copenhagen High expectations in UNFCCC 15, Dec 2009 Copenhagen Pre-occupation of policy-makers with financial crisis 2007, Nobel peace prize, IPCC and Al Gore 2007, Stern Report No clear statements from scientists Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

11. Climate policy impacts of the financial crisis before Nov 2008 after UNFCCC 15 failure in Copenhagen High expectations in UNFCCC 15, Dec 2009 Copenhagen Pre-occupation of policy-makers with financial crisis 2007, Nobel peace prize, IPCC and Al Gore 2007, Stern Report No clear statements from scientists Climate highlighted by all political leaders (e.g. Obama, Merkel,..) Climate becomes a political no-word (cf. Obama-Romney debates)

12. In fact, the two problems cannot be separated climate policy financial crisis

13. In fact, the two problems cannot be separated climate policy financial crisis 1. The resolution of the recession and sovereign debt problems following the financial crisis requires major new public and private investments

14. In fact, the two problems cannot be separated climate policy financial crisis 1. The resolution of the recession and sovereign debt problems following the financial crisis requires major new public and private investments 2. Renewable energy technologies and enhanced energy efficiency provide ideal opportunities for investment - creating many new jobs - with wide support in the public

15. In fact, the two problems cannot be separated climate policy financial crisis 1. The resolution of the recession and sovereign debt problems following the financial crisis requires major new public and private investments 2. Renewable energy technologies and enhanced energy efficiency provide ideal opportunities for investment - creating many new jobs - with wide support in the public So how did this disconnect between logic and the political process arise?

16. An explanation: Climate scientists and economists have lost credibility with policy-makers and the public in their recommendations of the appropriate policy response to climate change

17. An explanation: • Climate scientists and economists have lost credibility with policy-makers and the public in their recommendations of the appropriate policy response to climate change • because: • economists failed to predict the financial crisis, through their belief in the self-rectifying forces of the free market

18. An explanation: • Climate scientists and economists have lost credibility with policy-makers and the public in their recommendations of the appropriate policy response to climate change • because: • economists failed to predict the financial crisis, through their belief in the self-rectifying forces of the free market • most integrated-assessment models have similarly been based on the efficient-market paradigm - ignoring the instabilities that led to the financial crisis. So how can they be relevant for solving the financial crisis and initiating a green transformation?

19. Thus, we need a new generation of integrated assessment models. Ideas: see set of papers in forthcoming Thematic Issue “Innovative Approaches to Global Change Modelling” of Ecological Modelling and Software With lead article by Carlo Giupponi, Mark Borsuk, Bert de Vries and KH (based on two workshops of the Global Climate Forum – formally European Climate Forum - in Bekkjarvik, 2009 and Utrecht, 2010)

20. For impact on stakeholders and climate policy, the models would need to incorporate the following features: • simple, easily understandable, addressing the current political debate

21. For impact on stakeholders and climate policy, the models would need to incorporate the following features: • simple, easily understandable, addressing the current political debate • realistic representation of the coupling between the real economy and the financial system

22. For impact on stakeholders and climate policy, the models would need to incorporate the following features: • simple, easily understandable, addressing the current political debate • realistic representation of the coupling between the real economy and the financial system • inclusion of the inherent instabilities of the coupled system

23. For impact on stakeholders and climate policy, the models would need to incorporate the following features: • simple, easily understandable, addressing the current political debate • realistic representation of the coupling between the real economy and the financial system • inclusion of the inherent instabilities of the coupled system • representation of the conflicting strategies between different economic actors that give rise to the instabilities – in particular, public-private conflicts

24. For impact on stakeholders and climate policy, the models would need to incorporate the following features: • simple, easily understandable, addressing the current political debate • realistic representation of the coupling between the real economy and the financial system • inclusion of the inherent instabilities of the coupled system • representation of the conflicting strategies between different economic actors that give rise to the instabilities – in particular, public-private conflicts • system-dynamic evolution rather than utility optimization

25. An example: MADIAMS: Multi-Actor Dynamic Integrated Assessment Model System MADIAM: Weber et al, Ecolog, Econ. 2005; MADIAMS: KH and Voinov, in “Reframing the Problem of Climate Change”, Earthscan, 2011 KH and Kovalevsky, Environ. Mod. Softw, in press, KH, Tellus, submitted

26. An example: MADIAMS: Multi-Actor Dynamic Integrated Assessment Model System MADIAM: Weber et al, Ecolog, Econ. 2005; MADIAMS: KH and Voinov, in “Reframing the Problem of Climate Change”, Earthscan, 2011 KH and Kovalevsky, Environ. Mod. Softw, in press, KH, Tellus, submitted MADIAMS: S = system: the model is designed as a hierarchical model family.

27. An example: MADIAMS: Multi-Actor Dynamic Integrated Assessment Model System MADIAM: Weber et al, Ecolog, Econ. 2005; MADIAMS: KH and Voinov, in “Reframing the Problem of Climate Change”, Earthscan, 2011 KH and Kovalevsky, Environ. Mod. Softw, in press, KH, Tellus, submitted MADIAMS: S = system: the model is designed as a hierarchical model family. Here, a simple version: 7 actors; real-economy sector:3 state variables; financial sector: 11 state variables

28. Simple version: real economy, state variables r capital associated with renewable energy technology k capital associated with conventional energy technology g consumer goods and services

29. Simple version: real economy, state variables r capital associated with renewable energy technology k capital associated with conventional energy technology g consumer goods and services Total production y = yr + yk + yg with y = y(r,k)

30. Simple version, real economy, state variables r capital associated with renewable energy technology k capital associated with conventional energy technology g consumer goods and services Total production y = yr + yk + yg with y = y(r,k) Growth path - determined by distribution yr = r y, yk = k y, yg = g y of y ( = GDP) between three production streams, with distribution factors r, k, g governed by actor strategies

31. total production stocks: capital and consumer goods flows: production flows: depreciation and consumption

32. Examples of two real-economy growth paths: BAU and GREEN (green transformation) g k GREEN BAU r = 0

33. BAU GREEN Conclusion: green policy incurs negligible long-term loss in GDP

34. BAU global warming GREEN welfare = y q exp(- 0.1 T2) GREEN GDP BAU employment level global warming - but has major impact on global warming and welfare

35. Results are consistent with many previous more detailed investigations (e.g.Stern report).

36. Results are consistent with many previous more detailed investigations (e.g.Stern report). But note: no cost-benefit analysis, no discounting of future against present, just common sense, first-order inference of assumed investment decisions. Value judgements (e.g. welfare) clearly stated.

37. Results are consistent with many previous more detailed investigations (e.g. Stern report). But note: no cost-benefit analysis, no discounting of future against present, just common sense, first-order inference of assumed investment decisions. Value judgements (e.g. welfare) clearly stated. Interaction with the financial sector: A given real-economy growth curve can correspond to many different wealth curves of individual actors in the financial sector

38. Financial sector Actors: household (workers, consumers) r-firm (renewable-energy based) k-firm (conventional-energy based) r-investor (renewable-energy based) k-investor (conventional-energy based) government central bank State variables: liquidity for all actors, plus assets for investors

39. The financial sector: a highly simplified projection of reality, but already with 11 state variables and innumerable flows and interaction parameters. The concept of “rational perfectly informed economic actors” operating in an inherently stable system is clearly unrealistic

40. BAL DEF DEF BAL BAL DEF DEF BAL Two possible evolution paths of the financial sector for the real-economy growth path R-BAU: (1) BAL (all budgets balanced) and (2) DEF deficit government budget. Welfare is enhanced, but the government debt is sustainable only as long as creditors don’t balk.

41. How is it possible to have to two (or many more) alternative evolution paths of the financial sector for the same real-economy growth path? Should economic systems not always adjust to a unique equilibrium according to basic economics?

42. Textbook view of equilibrium established between supply, demand and price (e.g. Samuelson and Nordhaus, Abel and Bernanke)

43. System dynamics representation of supply-demand-price interdependence dS/dt = F (S,D,P) (S = supply) dD/dt = G (S,D,P) (D = demand) dP/dt = H (S,D,P) (P = price)

44. System dynamics representation of supply-demand-price interdependence dS/dt = F (S,D,P) (S = supply) dD/dt = G (S,D,P) (D = demand) dP/dt = H (S,D,P) (P = price) • General result: A Lorenz-type system of three 1st -order differential equations can have many solutions: • a damped periodic or monotonic transition to an equilibrium point • a stable convergence to a periodic attractor • an unstable trajectory diverging to infinity • a bounded, non-periodic chaotic trajectory

45. System dynamics representation of supply-demand-price interdependence dS/dt = F (S,D,P) (S = supply) dD/dt = G (S,D,P) (D = demand) dP/dt = H (S,D,P) (P = price) • General result: A Lorenz-type system of three 1st -order differential equations can have many solutions: • a damped periodic or monotonic transition to an equilibrium point • a stable convergence to a periodic attractor • an unstable trajectory diverging to infinity • a bounded, non-periodic chaotic trajectory • Which type of solution is realized depends on the initial conditions and the behaviour of the economic actors

46. Example 1: Stable actor behavior assumed in the standard supply-demand diagram, yielding equilibrium in supply, demand & price. Demand Price Demand = stabilizing feedback loop

47. Example 2: low-confidence consumer-producer behavior leading to business cycles (see mental models of many classical economists). Demand Supply Demand = destabilizing feedback

48. Example 3: Speculative demand and supply behavior in asset markets, leading to a boom-and-bust limit cycle (e.g. the dot.com bubble) Price Demand Price = destabilizing feedback

49. Other examples of non-equilibrium financial imbalances: Over-exposed banking sector through enhanced risk taking of investors stimulated by innovative financial products such CDSs (credit default swaps) and CDOs (Colaterized Debt Obligations)

50. Other examples of non-equilibrium financial imbalances: Over-exposed banking sector through enhanced risk taking of investors stimulated by innovative financial products such CDSs (credit default swaps) and CDOs (Colaterized Debt Obligations) (claimed by proponents to distribute risk, but actually enhances overall risk by encouraging investors to take risks they would otherwise not have taken)