The UK economy in a warming world

Good afternoon from New Economy Brief

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Last week the Office for Budget Responsibility (OBR) released its fiscal risks and sustainability report – an underappreciated and often misunderstood annual analysis of the long term sustainability of the UK public finances. The report highlights key risks to the government’s current and future fiscal position over the next 50 years, and updates its previous predictions about both the cost of transitioning the UK economy to net zero emissions and the cost of climate damages.

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This week's New Economy Brief explores why the OBR now believes net zero is cheaper than previously thought, climate damages are more expensive than previously thought, and why we should still expect this to understate climate change's impact on the economy. We’ll also look at why we need more investment in climate adaptation to make the UK economy more resilient to the effects of a warming world.

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Fiscal risks and sustainability of the public finances

This year’s report doesn't pull its punches, warning that the public finances are in a “relatively vulnerable position” due to turbulent bond markets, rising pension costs, climate change and the costs of global instability (e.g. trade frictions, cyberattacks and the need to spend more on defence). Much media commentary has focused on the costs of achieving the UK’s climate targets. However, this entirely misses the key conclusion from the report: that mitigating climate change will cost less than the OBR assumed until recently, but also that GDP losses will be far worse than previously estimated. In fact, damage from climate change will cost the government an estimated six times more than transitioning the economy to net zero emissions. 

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Getting to net zero is “cheaper than previously expected”. The OBR reduced its estimate for the overall economic cost of transitioning to a net zero economy by 2050 to £116bn over 25 years, some £204bn lower than previously expected. The key driver for this is that clean technology is becoming cheaper more quickly than expected, reducing the cost of low-carbon investment. To put this in context, Carbon Brief calculates that “in very rough terms, this figure – which excludes health co-benefits due to cutting emissions and avoided climate damages – is equivalent to less than £70 per person per year.”

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Climate damage “more severe than previously thought”. Estimating the cost of climate damage is highly uncertain, and the OBR has suggested a range of estimates based on different levels of warming and different impacts. Its central scenario of 3°C of warming above pre-industrial levels would hit UK GDP by nearly 8% per year by the 2070s, which could explode the government’s debt-to-GDP ratio. The OBR explains that the largest impact of climate damages on government borrowing is “lower productivity and employment and, therefore, lower tax receipts”. Beyond these new numbers, the OBR acknowledges that it still does not include the cost of adapting to climate change in this report, or how far this could reduce damages (it aims to assess this “in the coming years”). While government has also given relatively little attention or funding to adaptation so far, Green Alliance’s Climate Adaptation Task Force has published a new briefing explaining why “smart adaptation measures are an 'invest to save' opportunity, generating economic activity while protecting communities from escalating climate impacts.”

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The UK economy in a 3°C world.

The world is on track to exceed the Paris Agreement ambition of limiting warming to 1.5°C within the next five years. Even 2°C would likely render vast parts of the world “essentially uninhabitable”, directly affecting a third of humanity, and the United Nations has projected that the world is currently on track for about 3.1 degrees of warming. So how would the UK economy and public finances fare in a 3°C world? The OBR tries to answer this question using the Network for Greening the Financial System (NGFS)’s forecasts. Let’s explore what the consequences of this increase in temperatures could be before considering whether the OBR’s estimates look reasonable.

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What to expect from 3°C of warming. A report earlier this year from the Institute and Faculty of Actuaries warned that if the world heats up by 3°C or more by 2050, there could be more than 4 billion deaths, worldwide social and political fragmentation including the failure of states (with resulting “rapid, enduring, and significant loss of capital”), and a “high level of extinction of higher order life on Earth”. Climate damages are already severe with unprecedented fires, floods, heatwaves, storms and droughts. But they have the potential to become “catastrophic”, leading to the “loss of capacity to grow major staple crops, multi-metre sea level rise, [and] altered climate patterns”. We also risk triggering various ‘tipping points’, such as the collapse of the Atlantic Meridional Overturning Circulation (AMOC) - which could cause UK winters to resemble those in Northern Norway - or melting of the Greenland ice sheet - which could increase the sea level by up to 7 metres. 

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(It is important to understand that climate damage isn't just the direct impacts of extreme weather, but also the productivity we'll lose to reduced labour output, supply chain disruptions, and the collapse of crucial industries “in all countries and across all sectors”, which another report predicts could contribute to reducing global economic output by a third.)

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So how accurate is the OBR’s central scenario? The NGFS estimate used by the OBR excludes many of these real-world impacts of climate change. As the OBR acknowledges, it doesn’t model these “large, irreversible changes to the Earth’s climatic system”, the impact of sea level rise, migration, higher risk of epidemics and pandemics or the “disruption of global supply chains which are essential to much of the UK’s economic activity”. The Institute and Faculty of Actuaries concluded that a “prudent approach would be to take the highest estimate of economic loss and reduce it when evidence becomes available that it is over-stated, rather than the other way round.” The OBR’s central estimate of an 8% loss of UK output, however, seems more likely to be an underestimate.

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Fiscal performativity. This matters because if the OBR underestimates the damage climate change will do to the UK economy, governments are less able to see the urgency of responding, and the value for money they can get from upfront, precautionary spending to prevent these damages. That could be anything from making our food system more sustainable to upgrading our flood defences or supporting global efforts to cut emissions (on which the government’s aid cuts are taking us in the wrong direction). 

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Greening the fiscal framework. Even based on the OBR’s small-c conservative assumptions, the case for climate action – and for the vastly greater costs of inaction – is clear. Failing to tackle the UK economy’s vulnerabilities to climate damages, for example by investing in adaptation, is grossly irresponsible. The fiscal framework needs to be redesigned to ensure that these longer-term, ‘potentially catastrophic’ risks are being addressed and that Chancellors are held to account for underfunding the measures needed to take to protect the economy and people’s livelihoods. As a minimum, the scale and growing immediacy of climate risks mean that rather than keeping them separate, they should be integrated into the OBR’s regular Economic and Fiscal Outlooks rather than tucked away in the long-term risks report (as recommended by the OBR’s latest external review). The Chancellor should then respond to them at fiscal events with at least as much seriousness as the OBR’s key economic forecasts, focusing more on big, systemic risks to the public finances and less on minor breaches of fiscal headroom.