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Climate economics is the branch of environmental economics that studies the economic causes, consequences, and policy responses to anthropogenic climate change. It treats the emission of greenhouse gases as a global externality: a side effect of economic activity that imposes costs on others, including future generations, without those costs being reflected in market prices. The field's central task is to understand how much climate change will cost, how much it will cost to avoid, and how societies should weigh those two sets of costs against each other.
The foundational insight of climate economics is that greenhouse gas emissions are a textbook case of market failure. When a firm burns coal or a driver uses gasoline, the resulting carbon dioxide spreads globally and remains in the atmosphere for centuries. The emitter bears only the private cost of the fuel, not the social cost—the present and future damages from altered temperature, sea-level rise, extreme weather, and disrupted ecosystems. Because no market price exists for the right to emit carbon, markets produce too much emission and too little clean energy.
This framing generates the field's central questions. First, what is the social cost of carbon—the monetary value of the damage caused by one additional ton of carbon dioxide emitted today? Second, what policy instruments—carbon taxes, cap-and-trade systems, regulations, subsidies—can most efficiently correct the externality? Third, how should the costs of mitigation be distributed across countries, given that emissions are global but the capacity to pay and the vulnerability to damage vary enormously? Fourth, how should present generations weigh the welfare of future generations, who will bear the brunt of today's emissions?
Climate economics emerged in the 1970s and 1980s as scientists began to understand the greenhouse effect and economists began to apply the tools of cost-benefit analysis to environmental problems. Early work focused on energy modeling and the costs of reducing emissions, often in the context of oil price shocks and energy security. The field consolidated around a set of integrated assessment models (IAMs) that combine a simplified climate model with an economic growth model, allowing researchers to trace the feedback between emissions, temperature, and economic output.
The 1990s brought the first major international climate treaty, the United Nations Framework Convention on Climate Change, and with it a surge of economic analysis on burden-sharing and the design of international agreements. The Kyoto Protocol of 1997 introduced the idea of binding emission targets for developed countries and flexible mechanisms like emissions trading, which economists had long advocated. The field matured further in the 2000s with the publication of the Stern Review in the United Kingdom, which argued that the costs of inaction far outweigh the costs of mitigation, and with the growing sophistication of models that incorporated uncertainty, risk, and the possibility of catastrophic thresholds.
Climate economics is not a single unified framework but a field organized around several distinct approaches that often coexist and sometimes conflict.
The dominant approach in climate economics is cost-benefit analysis conducted through integrated assessment models. These models combine a climate module that translates emissions into temperature change with an economic module that translates temperature change into damages and mitigation costs. The most influential IAMs include the DICE model (Dynamic Integrated Climate-Economy), developed by William Nordhaus, and the PAGE and FUND models used in government assessments.
The organizing assumption of this approach is that climate policy should maximize net present welfare: the discounted sum of future benefits from avoided damages minus the costs of emission reductions. This requires estimating the social cost of carbon, which then serves as the benchmark for policy. If a carbon tax is set equal to the social cost of carbon, emitters will internalize the externality and the market will produce the efficient level of emissions.
The approach has several well-known limitations. The damage functions in IAMs are highly uncertain, particularly for large temperature increases where empirical evidence is thin. The models also require a discount rate to compare costs and benefits across centuries, and small changes in this rate produce enormous differences in recommended policy. A low discount rate—reflecting a strong ethical commitment to future generations—justifies aggressive near-term mitigation; a high discount rate—reflecting the expectation that future generations will be wealthier and better able to adapt—justifies slower action. This choice is fundamentally ethical, not empirical, and it has been the subject of intense debate.
A second approach, associated with the Stern Review and with economists like Martin Weitzman, argues that standard cost-benefit analysis underestimates the risks of climate change. This perspective emphasizes deep uncertainty: we do not know the probability distribution of climate sensitivity, the possibility of tipping points like the collapse of the Greenland ice sheet or the Amazon rainforest, or the economic consequences of extreme warming. Weitzman's "dismal theorem" suggests that under plausible conditions, the expected welfare loss from climate change may be infinite because the tails of the damage distribution are too fat.
The policy implication is that mitigation should be understood as insurance against catastrophic risk rather than as an investment with a calculable return. This approach justifies more aggressive emission reductions than standard cost-benefit analysis would recommend, even when the discount rate is high. Its limitation is that it provides less precise guidance: if the goal is to avoid catastrophic thresholds rather than to equate marginal costs and benefits, the policy question becomes how much insurance to buy and how to define the threshold.
A third approach focuses on the strategic and institutional dimensions of climate policy. Climate change is a global public good: no single country can solve it alone, and each country has an incentive to free-ride on the mitigation efforts of others. This approach, drawing on game theory and public choice, asks how international agreements can be designed to be self-enforcing, how to allocate emission rights fairly, and how to make commitments credible.
This perspective explains why international climate negotiations have been difficult. The Kyoto Protocol's binding targets for developed countries were not joined by the United States and did not cover major emitters like China and India. The Paris Agreement of 2015 took a different approach, with voluntary nationally determined contributions and a pledge-and-review mechanism. Economists in this tradition study the conditions under which such agreements can be stable, the role of trade sanctions and border carbon adjustments, and the potential for clubs of like-minded countries to provide leadership.
The limitation of this approach is that it is more descriptive than prescriptive. It explains why cooperation is hard but offers less guidance on what the optimal level of global mitigation should be. It also tends to treat national governments as unitary actors, obscuring the domestic political economy of climate policy.
A fourth approach focuses on the economics of the energy transition itself. Rather than asking how much to reduce emissions, it asks how to reduce them at the lowest cost. This work examines the economics of renewable energy, energy efficiency, carbon capture and storage, nuclear power, and the electrification of transport and industry. It studies learning curves—the tendency of technology costs to fall with cumulative production—and the role of research and development, subsidies, and infrastructure investment.
This approach has become increasingly important as the costs of solar and wind power have fallen dramatically. It emphasizes that the choice of policy instrument matters for technological innovation: carbon pricing creates incentives for all forms of abatement, while technology-specific policies can accelerate particular innovations but risk picking winners. The field also studies the challenges of integrating variable renewable energy into electricity grids, the economics of energy storage, and the political economy of fossil fuel phase-out.
The limitation of this approach is that it can understate the urgency of the problem. If the focus is on the cost of the transition, there is a risk of treating climate policy as a gradual technological transformation rather than as a response to an accelerating crisis. It also tends to assume that clean technologies will be adopted if they become cheap enough, without fully addressing the institutional, behavioral, and distributional barriers to adoption.
The present landscape of climate economics is characterized by several durable features. First, the social cost of carbon remains the central organizing concept, even as its estimation remains contested. Governments use it in regulatory impact analysis, and it provides a common metric for comparing policies. The U.S. government's estimates have varied significantly across administrations, reflecting both scientific uncertainty and political influence.
Second, the field has moved from asking whether to mitigate to asking how fast and through what mix of policies. The Paris Agreement's goal of limiting warming to well below 2°C, and ideally 1.5°C, has focused attention on carbon budgets—the total amount of carbon that can be emitted while staying within a temperature target. This framing shifts the question from the social cost of carbon to the cost of staying within a budget, which is a different optimization problem.
Third, distributional concerns have moved from the periphery to the center. Climate change affects poor countries and poor people within countries more severely, both because they are more exposed to climate impacts and because they have fewer resources to adapt. Mitigation policies also have distributional consequences: carbon taxes are regressive unless revenues are used to compensate low-income households. The field now routinely studies the distributional effects of both climate damages and climate policies, and the design of just transitions for workers in fossil fuel industries.
Fourth, the field has become more interdisciplinary. Climate economists increasingly work with climate scientists, engineers, political scientists, and behavioral economists. The recognition that climate change involves deep uncertainty, irreversible thresholds, and ethical choices has pushed the field beyond the narrow cost-benefit framework toward a broader consideration of risk, equity, and institutional design.
Fifth, the field remains divided on the most fundamental question: how much should we sacrifice today to protect the future? This division is not a sign of immaturity but a reflection of genuine ethical disagreement. The choice of discount rate, the treatment of catastrophic risk, and the weight given to the welfare of the poor and of future generations are value judgments that economics can inform but not resolve. The field's contribution is to make these choices explicit, to quantify their consequences, and to design policies that are robust across a range of ethical positions.