Climate Change and the Financial Crisis

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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
after
Nov 2008
4
Climate policy impacts of the financial crisis
before
after
Nov 2008
High expectations in UNFCCC 15, Dec 2009
Copenhagen
5
Climate policy impacts of the financial crisis
before
after
Nov 2008
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
after
Nov 2008
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
after
Nov 2008
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
after
Nov 2008
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
after
Nov 2008
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
after
Nov 2008
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
after
Nov 2008
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)
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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
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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
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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?
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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
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• 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

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• 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?

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

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• 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

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• 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

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• 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

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• 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

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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
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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.
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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 sector3
state variables financial
sector 11 state variables
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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
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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)
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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
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total production
stocks capital and consumer goods
flows production
flows depreciation and consumption
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Examples of two real-economy growth paths

BAU and

GREEN (green transformation)
?g
?k
GREEN
BAU
?r 0
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Conclusion green policy incurs negligible
long-term loss in GDP
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- but has major impact on global warming and
welfare
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Results are consistent with many previous more
detailed investigations (e.g.Stern report).
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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.
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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
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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
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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
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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 dont balk.
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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?
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Textbook view of equilibrium established between
supply, demand and price (e.g. Samuelson and
Nordhaus, Abel and Bernanke)
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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)
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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

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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

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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
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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)
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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)
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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)
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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
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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
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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
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BAL
SAV
DEF
SAV
REC
BAL
REC
DEF
REC
employment
DEF
REC
BAL
SAV,
SAV
BAL
REC
REC
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
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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.
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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
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• Conclusions
• None of these examples are new, but in contrast
  to many integrated assessment models in the
  literature, they reflect the current political
  debate

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• 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

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• 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

61

• 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

62

• 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

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Thanks for listening Discussion welcome