Climate Change and the Financial Crisis Klaus Hasselmann Max Planck Institut for Meteorology,...

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

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

Climate policy impacts of the financial crisisbefore afterNov 2008

Climate policy impacts of the financial crisisbefore afterNov 2008

High expectations in UNFCCC 15, Dec 2009 Copenhagen

Climate policy impacts of the financial crisisbefore afterNov 2008

2007, Nobel peace prize, IPCC and Al Gore

High expectations in UNFCCC 15, Dec 2009 Copenhagen

Climate policy impacts of the financial crisisbefore afterNov 2008

2007, Nobel peace prize, IPCC and Al Gore

2007, Stern Report

High expectations in UNFCCC 15, Dec 2009 Copenhagen

Climate policy impacts of the financial crisisbefore afterNov 2008

2007, Nobel peace prize, IPCC and Al Gore

2007, Stern Report

Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

High expectations in UNFCCC 15, Dec 2009 Copenhagen

Climate policy impacts of the financial crisisbefore afterNov 2008

2007, Nobel peace prize, IPCC and Al Gore

2007, Stern Report

Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

UNFCCC 15 failure in Copenhagen

High expectations in UNFCCC 15, Dec 2009 Copenhagen

Climate policy impacts of the financial crisisbefore afterNov 2008

2007, Nobel peace prize, IPCC and Al Gore

2007, Stern Report

Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

UNFCCC 15 failure in Copenhagen

Pre-occupation of policy-makers with financial crisis

High expectations in UNFCCC 15, Dec 2009 Copenhagen

Climate policy impacts of the financial crisisbefore afterNov 2008

2007, Nobel peace prize, IPCC and Al Gore

2007, Stern Report

Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

UNFCCC 15 failure in Copenhagen

Pre-occupation of policy-makers with financial crisis

No clear statements from scientists

High expectations in UNFCCC 15, Dec 2009 Copenhagen

Climate policy impacts of the financial crisisbefore afterNov 2008

2007, Nobel peace prize, IPCC and Al Gore

2007, Stern Report

Climate highlighted by all political leaders (e.g. Obama, Merkel,..)

UNFCCC 15 failure in Copenhagen

Pre-occupation of policy-makers with financial crisis

No clear statements from scientists

Climate becomes a political no-word (cf. Obama-Romney debates)

High expectations in UNFCCC 15, Dec 2009 Copenhagen

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

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

In fact, the two problems cannot be separated

climate policy financial crisis

In fact, the two problems cannot be separated

climate policy financial crisis1. 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?

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

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:

1. economists failed to predict the financial crisis, through their belief in the self-rectifying forces of the free market

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:

1. economists failed to predict the financial crisis, through their belief in the self-rectifying forces of the free market

2. 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?

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)

For impact on stakeholders and climate policy, the models would need to incorporate the following features:

• simple, easily understandable, addressing the current political debate

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

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

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

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

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

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.

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

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

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)

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

flows: production flows: depreciation and consumption

stocks: capital and consumer goods

total production

Examples of two real-economy growth paths: BAU and GREEN (green transformation)

GREENBAU

r = 0

g

k

BAU

GREEN

Conclusion: green policy incurs negligible long-term loss in GDP

BAU

BAU

GREEN

GREENwelfare = y q exp(- 0.1 T2)

employment level

GDP

global warming

global warming

- but has major impact on global warming and welfare

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

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

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.

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)governmentcentral bank

State variables:

liquidity for all actors, plus assets for investors

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

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.

BAL

BAL

BAL

BAL

DEF

DEF

DEF

DEF

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?

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

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)

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

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

System dynamics representation of supply-demand-price interdependence

Example 1: Stable actor behavior assumed in the standard supply-demand diagram, yielding equilibrium in supply, demand & price.

Demand Price Demand = stabilizing feedback loop

Example 2: low-confidence consumer-producer behavior leading to business cycles (see mental models of many classical economists).

Demand Supply Demand = destabilizing feedback

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

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)

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)

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)

Persistent sovereign debt – as in the example shown (e.g. Euro crisis)

Government policies that prevent these instabilities is a pre-condition for creating the confidence in the economy needed to encourage long-term investments in the green transformation.

Thus:

financial stabilization green transformation

Government policies that prevent these instabilities is a pre-condition for creating the confidence in the economy needed to encourage long-term investments in the green transformation.

Thus:

financial stabilization green transformation

but also

green transformation financial stabilization

Government policies that prevent these instabilities is a pre-condition for creating the confidence in the economy needed to encourage long-term investments in the green transformation.

Thus:

financial stabilization green transformation

but also

green transformation financial stabilization

Applied to our example: sovereign debt

DEF

DEF

DEF

BAL

BAL

BAL

BAL

SAVSAV

SAV,SAV

REC

REC

REC

REC

REC

employment

Alternative assumptions on impacts of a savings strategy to re-adjust the DEF trajectory to the BAL trajectory:

SAV: assumes self-stabilizing forces of the free market

REC: predicts a major recession and unemployment through unstable feedbacks

REC

The data for Southern Europe clearly favours the recession model over the stable-market-response model.

Alternative to austerity model:

Keynes - combine savings (if at all) with government sponsored investments in the real economy – for example, in green technologies.

Comparison of the pure savings, recession creating, strategy REC with a combined savings plus Keynes-type enhanced green investment strategy GR-INV. Also shown: the reference non-feedback green strategy GREEN

Conclusions:

• None of these examples are new, but in contrast to many integrated assessment models in the literature, they reflect the current political debate

Conclusions:

• None of these examples are new, but in contrast to many integrated assessment models in the literature, they reflect the current political debate

• The models are very simple, easy to understand and communicate, and can be constructed in a few days

Conclusions:

• None of these examples are new, but in contrast to many integrated assessment models in the literature, they reflect the current political debate

• The models are very simple, easy to understand and communicate, and can be constructed in a few days

• In contrast to their simplicity, they often reveal unexpected dynamics through their stocks-and-flows time separation of input and response

Conclusions:

• None of these examples are new, but in contrast to many integrated assessment models in the literature, they reflect the current political debate

• The models are very simple, easy to understand and communicate, and can be constructed in a few days

• In contrast to their simplicity, they often reveal unexpected dynamics through their stocks-and-flows time separation of input and response

• The models should be constructed interactively with stakeholder and policy-makers in a participatory mode

Conclusions:

• None of these examples are new, but in contrast to many integrated assessment models in the literature, they reflect the current political debate

• The models are very simple, easy to understand and communicate, and can be constructed in a few days

• In contrast to their simplicity, they often reveal unexpected dynamics through their stocks-and-flows time separation of input and response

• The models should be constructed interactively with stakeholder and policy-makers in a participatory mode

• The models need to be calibrated against data. The examples given here were calibrated only against mean growth “stylized facts”. Interaction parameters were guessed

Thanks for listening

Discussion welcome