German CDU leader Friedrich Merz believes climate protection is overrated in politics. “It’s not like the world will end tomorrow.” By saying this, he shows that he does not understand where the climate is blowing. Economists and central bankers explain why.

Putting the economy before the environment is an illusion. Italian President Sergio Mattarella said as much during a state visit to Kenya last March.

'In the face of impending catastrophe' limited action is unwise; ‘faithless inaction will be fatal”, he added, quoting his Kenyan counterpart Ruto.

Today, no nation can find lasting security without addressing the climate crisis. Climate change is accelerating, and there is a growing realisation that the risks and economic costs of climate change have been grossly underestimated. 

Suddenly, the world has discovered that nature is system relevant. 

The international community is prompted to act. Decisions postponed for decades have been made since 2018. The Green Deal has set in motion a systemic transformation of EU industries, economies, and societies. China and the USA have followed suit. International treaties are redrawing the contours and operating limits of the economic model.

In March, states endorsed a historic agreement to forge an international legally binding agreement by 2024 to end plastic pollution. Last year, a historic accord to protect biodiversity was reached at COP25 in Montreal.

Humanity knows it must learn to respect the biogeochemical limits of the planet to operate within planetary boundaries. Eventually, life itself depends on the cycles of carbon, nitrogen, phosphorous, water and oxygen.

To ignore life’s natural borders, the carrying capacity of the planet, and the value of life-supporting ecosystem functions provided to us, is a market failure.

Climate change involves a fundamental failure of markets

For decades, classical economic theory and econometric models have grossly underestimated the economic impacts of the crisis. Models do not capture the real cost of exhausting non-renewable natural resources, nor that of externalities. What’s even worse is the fact that the models systematically ignored the risk of overshooting the tipping points that would impact all planetary sub-systems with fatal consequences. “It’s the economy, stupid” someone famously said. Right, but the math was wrong.

Economist William Nordhaus won the Nobel prize “for integrating climate change into long-run macroeconomic analysis”. While he was among the first to call for a carbon tax, his models are flawed. 

For him, an increase of 3.5 degrees by 2100 might be an economically desirable outcome. The “cost-benefit optimum”, which is the optimal result of a cost-benefit analysis of the economy of climate change, would be reached with a global temperature rise of 4 degrees Celsius by 2150. 

This might constitute a theoretical construct of the utmost elegance. Too bad that since 2018, with an increase of 1.2 degrees, Europe has been in a drought. A rise of over 3 degrees would make large parts of the world simply uninhabitable. 

It is therefore rather unfortunate that the DICE model (Dynamic Integrated Climate Economy model), which is the basis of the Nordhaus Integrated Assessment Models (IAM), somewhat paradoxically concludes that a 6-degree rise would cause a limited loss of 10% of global GDP. 

To put things in perspective, a 6-degree increase would turn the Earth into a scorching wasteland. 

The true cost of failing nature 

Then, what is the real social cost of carbon? Carbon prices need to reach $130/ton by 2030 to achieve the Paris objectives; how will economic systems cope with the change? As climate change intensifies, it will be the dominant factor shaping the macroeconomic variables. The idea of a design fault in the economic system is becoming increasingly established.

And when markets fail, the need for political action kicks in. In the face of climate change, “the market won’t save us, regulation will”. These are the words of the Vice President of the European Commission, responsible for the Green Deal, Frans Timmermans.

This was unthinkable just a few years ago. Today, such a statement is almost mainstream. Economists and central bankers are changing the narrative. 

Central banks spent a decade fixing the design faults of the financial system after the 2008 crisis. Today all eyes are on a challenge of far different existential magnitude, improving the climate resilience of the financial system and the global economy. 

Stopping climate change “requires strong political determination” and commitment. The responsibility lies with national governments, the only institutions that “can incentivise ‘green’ investments, levy taxes on carbon and impose limits on the amount of emissions that can be allowed”, according to Ignazio Visco, Governor of the Bank of Italy.

US Treasury Secretary Janet Yellen recently warned that losses tied to climate change are already causing significant costs and could 'cascade through the financial system'.

Central banks must do their part to tackle the climate crisis while the ECB “must adapt its macroeconomic models to integrate climate change risks into monetary policy”, argues Isabel Schnabel, an Executive Board member of the ECB.

The first, historic climate risk stress test that the European Central Bank (ECB) conducted last year showed that most banks are not ready as they lack a climate risk stress-testing framework and do not include climate risk in their credit risk models, thus posing a risk to financial stability in Europe.

We expect “greater information on the exposure of individual companies”, as well as clarity on the “sustainability of financial products” to ensure that climate risks are “adequately priced”.

"The 'true social and environmental cost of carbon' must be included in the prices paid by all sectors of the economy”, said ECB President Lagarde. 

Companies, economists, and bankers will try to keep the price down. In the end, nature will dictate its terms.

illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.