Sustainability Economics

• Introduction to Sustainability Economics
• Economic Growth, Sustainability, Market Failures
  • Macroeconomic Refresher
  • Microeconomic Refresher
  • Integraded Assessment Models (IAMs) and the DICE Model
• Quantifying the Economic Value of the Environment, Part 1
• Quantifying the Economic Value of the Environment, Part 2
• Market Value of Firms’ Sustainability Investments
• Costs of Sustainability Investments: Basics
• Firm’s Capital Costs and Environmental Risks
• Sustainability Costs: Managerial and Technological Innovation
• Principles of Benefit-Cost Analysis (BCA)
• Extensions of BCA: Distribution, Substitutability, and Uncertainty
• Environmental Policy: Instrument Choice and Efficiency
• Policy: Distribution and International Cooperation
• Collapse, Resilience, and Common Pool Resources
• Measuring Sustainable Development

1. Introduction

Economics is the study of how people use scarse resources and respond to incentives.

Sustanability economics tries to understand and manage the long-term relationships between humans and nature so that scare enviromental goods, and their human-made substitues or complements, are being used efficiently.

Sustainability approaches tries to understand what do we want to preserve:

• Income, consumption
• Wealth, capital
• Utility, social Welfare
• Possibilities, opportunities
• Nature, ecosystem
• ...

An Outcome-Oriented approach seek to preserve realized human well-being over time (actual experience).
An Opportunity-Oriented approach seek to preserve means to generate welfare (potential of the future).

In relation to this, we define Capital $K$ as stock that can be used to deliver a flow of services, and we distinguish:

• $K_h$: human capital (people, education, health)
• $K_p$: physical capital (infrastructure, machines, buildings)
• $K_n$: natural capital (ecosystem, atmosphere)

Comprehensive Wealth incluse the total value of all capital stocks.

- "Weak" sustainability use and invest in natural and human-made capital stock such that comprehensive wealth doesn't decline:

• "Strong" sustainability use and invest in natural and human-made capital stock such that no stock $i\in \{h,p,n\}$ falls below a critical level:

Example: a strong approach to climate change limits temperature change below critical levels (example: limit warming at 2° no matter of the cost).
A weak approach balances costs and benefits of emissions reductions (impose carbon tax to ensure that fossil fuels are only burned when their benefit exceed social cost).

2.1 Economic Growth, Sustainability, Market Failures - Macroeconomic Refresher

GDP (Gross Domestic Product) is the market value of the final goods and services produced within the borders of a country during a particular time period.
It can be measured in 3 ways:

• the production approach
• the expenditure approach
• the income approach

The idea behind the production approach is to sum up the market value of the final goods and services produced in a year.

Example: Giacomo's Racing Bikes
Giacomo's Land is a small country with one employer (Giacomo's GmbH) that produces 100 racing bikes a year. The market price of an racing bike is $10^{\prime }000\text{ CHF}$ (yes, they are very expensive!).
All Giacomo's Land citizens work in the bike factory, that also owns all the machines, so it onlz needs to hire workers.

To determine the market value of production, we simply do:

Note that we focus to the final value at tend of the production chain (value added), so we sum the ssales revenues minus the firm's purchases of intermediate products to avoid double-counting.

The expenditure approach looks at the total value of expenditures on goods and services produced in the domestic economy by considering:

• $C$: consumption (good and servies bought by domestic households)
• $I$: new physical capital investments from domestic households and domestic firms
• $G$: government expenditures
• $X$: exports of goods and servies produced domestically and sold abroach
• $M$: imports of goods and services produced abroad and sold domestically

and calculating GDP ($Y$) as:

Nominal GDP is the total value of production using current market prices to determine the value of each unit.

• An increase in GDP will record both increases in actual production and increases in the prices of goods and services.

Real GDP is the total value of production using constant market prices_.

Real GDP allows then to compute real changes in output across time since we adjust for the price levels.

In a similar way, PPP (Purchasing Power Parity) adusted income measures adjust for differences in cost of living across locations:

A very useful tool to visualize PPP adjustments is Numbeo - Cost of Living .

For example, this comparison between Zurich and Naples shows absolute different in prices. If we want to compute PPP Adjustments, we simply do:

For example, in case we wanto to compare salaries, and we assume the following:

• average pizza-man salary in Naples: $25^{\prime }000$€
• average pizza-man salary in Zurich: $60^{\prime }000$€ we just have to re-compute the Zurich'one with the PPT adjustments:

meaning that purhcasing power of Zurich's pizza-men is actually higher.

We recall that the aggregate production function for GDP is:

• $K_t$: investment and construction
• $L_t$: labor force participation
• $h_t$: education
• $A_t$: improvements in technology, institutions, management etc...

However, in the long run, the only source of sustained GDP per capita growth is the growth in productivity $A_t$. (Note that, given the right incentives, market can direct productivity improvements in almost any direction).

Starting from the aggregate production function, the Integraded Assessment Modelds (IAMs) integrade enviromental and resource dynamics into macro-economic analysis.

Firstly, we can account for the role of (fossil) energy $E£ in the GDP production:

Intuition: using more (and cheap) energy today increases GDP today.

Then, we add climate model to account for effectsof fossil use energy on warking $T_t$:

and then we add $A_t$ to the GDP's formula:

Note that, in reality, energy consumption $E$ affects all the determinants of GDP, not only the productivity (for example, investments depends on depreciation rate, also affected by climate change). Most important, climate changes also has strong effects that don't affect GDP directly (non-market impacts such as elderly mortality, biodiversity etc etc...)

2.2 Economic Growth, Sustainability, Market Failures - Microeconomic Refresher

For a better review, please also refer to my microeconomic notes .

First Fundamental Theorem of Welfare Economics states that, in absence of market failures, free competitive markets lead to the economically efficient outcome.

• Intuition on the consumer side: consumers spend money on a given good until their marginal benefit from another slice is just equal to the marginal cost (the price they pay) of buying an additional unit.
• Intuition on the producer side: firms produce as much of a good until their marginal cost is just equal to the marginal revenue they sell at.

Markets allocate scarse resources efficiently because prices serve as a signal of the value and cost of using the resorces to produce a given good.

A market failure is a problem that causes the free market to deliver an outcome that is inefficient.

• Private marginal cost is the direct cost of producers of producing an additional unit.
• Social marginal cost is the private marginal cost plus any external costs or benefits of producing an additional unit.

Intuition: social marginal costs measure the full costs to society.

2.3 Economic Growth, Sustainability, Market Failures - Integrade Assessment Models (IAMs) and the DICE Model

IAMs are integrade models of the economy and the enviroment.
In macroeconomic, there are the following assumptions and behaviors:

• firms maximize profits
• households maximise well-being
• agents anticipate the future
• market equilibrium represents a solution.

Interdisciplary and policy IAMs often take these assumptions are given, but they miss the feedback loop: they calculate how growth affects the climate, but they struggle to calculate how much that climate change affects back into the economy.

The Nordhaus DICE Model (1992) is based on the Ramsey-Cass-Koopmans growth model, whose aggregate production function is:

where $Y_t^{gross}$ is the global gross output, $A_t$ the total factor productivity, $K_t$ the capital stock and $L_t$ the labor. (Note that many IAms also include energy services as production input).

The DICE models also introduce calculates the baseline industrial carbon emissions as:

where ${\sigma }_t$ is the baseline emissions intensity of the economy. (Note that, in the past ${\sigma }_t$ showed a linear-decading trend).

In addition to this baseline decarbonization trend, society can undertake additional efforts to reduce carbon emissions so, if we define ${\mu }_t\in [0,1]$ as the fraction of emissions reduced, we can model:

and then we represent the costs ${\Lambda }_t$ of emissions reductions as a share of GDP:

The Nordhaus DICE Model also accounts for CO2 emissions and, from the atmospheric carbon concentrations $M_{AT,t}$, it models the increased radiative forcing $F_t$ (measuring how much extra heat (in Watts per square meter) is being trapped at any given time $t$.)

• $\frac{M_{AT,t}}{M_{AT,1750}}$: This ratio compares the current amount of carbon in the atmosphere ($M_{AT,t}$) to the levels before the Industrial Revolution ($1750$).

• The Logarithm represents the diminishing returns of $C{O}_2$. Every time you double the concentration, you get a fixed increase in temperature.

• $\eta$ (Eta) is the climate sensitivity parameter

• $F_t^{Abate}$ & $F_t^{Ex}$: These represent forcings from sources other than $C{O}_2$ (like Methane or Aerosols).

Intuition: increasing $F_t\to$ increased temperatures.

The model indeed estimated the global atmospheric surface temperature change over pre-industrial levels, $T_t$ as a function of the history of CO2 emissions and other forcings:

Then, the model summarizes the climate change impacts on economy with a damage function $D(T_t),whichcapturesthefactionofGDP-equivalentlossfromwarming$T_t$, so we can write:

• reducing emissions (higher ${\mu }_t$) costs money today but reduces climate damage in the future ($T_t$ decreases)
• macro-level inter-temporal trade-off are analogous to standard consumption/saving decisions.

To understand the inter-temporal tradeoffs, we consider each household's lifetime utility $U$ as:

where $u(c_t)$ is concave function of utility of each household at period $t$ and $\rho$ the discount factor.

Recall that the final goal of the DICE model was to estimate the social cost of carbon (SSC), defined he total damage that one extra ton of carbon emitted today causes to the world for the rest of time.

Intuition: $SC{C}_t$ sums all the discounted future changes in utility (wealth effect), weighted by the effect on future GDP changes (economic damage) and the effect of future temperature changes (climate damage).

3. Quantifying the Economic Value of the Environment, Part 1

4. Quantifying the Economic Value of the Environment, Part 2

5. Quantifying the Market Value of Firms’ Sustainability Investments – Part 1

6. Costs of Sustainability Investments: Basics

7. Firm’s Capital Costs, Sustainability, and Environmental Risks

8. Sustainability Costs: Managerial and Technological Innovation

9. Principles of Benefit-Cost Analysis in the Climate Context

10. Extensions of Benefit-Cost Analysis: Distributional Weights, Limited Substitutability, and Uncertainty

11. Environmental Policy: Instrument Choice, Efficiency and Effectiveness

12. Environmental Policy: Distribution, Re-distribution and International Cooperation

13. Collapse, Resilience and the Sustainable Management of Common Pool Resources

14. Measuring Sustainable Development